This past year ushered in one of the largest refinancing booms ever, forecasted to have exceeded $2.7 trillion in volume through the year, according to Fannie Mae. Enticed by slashed Federal interest rates in response to COVID-19, homeowners rushed to refinance their homes to lock in lower rates and secure better monthly payments.
The boom is expected to continue into 2021, but begin subsiding by the end of the second quarter. What should investors consider before refinancing their investments in 2021 and what complications may arise?
When refinancing, you are essentially paying off a loan with a new loan, but with better rates and changes to the loan’s structure. With a refinance, you can change the makeup of your monthly cash flow in a few different ways.
Loan structure changes
If you have an adjustable-rate mortgage on a property, then you’re subject to potential fluctuations in interest, which can either increase or decrease your cash flow each month. With a refinance, you often can switch your loan to a fixed-rate option, which will lock in a set rate for the remainder of the loan’s term. As an investor, this makes calculating your amortization, monthly income, and tax deductions at the end of the year significantly easier and more stable. This is step one of refinancing to improve your life as an investor.
Another part of your mortgage’s structure is the required private mortgage insurance (PMI) on loans originated with less than 20% down. Your premium’s information is located in the Loan Estimate and Closing Disclosure forms.
The premium is typically added to the cost of your monthly mortgage payment, but in some situations, you may have paid for it up front. If you did, then you most likely won’t be able to get a refund for payments made to the premium after refinancing. However, if you chose to tack it on to your monthly payments, there are ways to get some of that money back.
The point is that your PMI can be removed after refinancing if your new mortgage balance is less than 80% of the home’s total value. This usually happens when home prices have appreciated.
For instance, let’s assume you invested in a property with 10% down five years ago. Today, the home’s value has appreciated by more than 15% and you move to refinance. You now have more than 20% equity in the home, so the lender might allow you to waive the PMI requirement, allowing for extra monthly cash flow.
Another way to visualize your monthly savings: Let’s say you bought a property for $150,000 and put 10% down. This means the mortgage is worth $135,000. When working with a fixed rate of 4% over 30 years, your monthly payment is $716 without accounting for property taxes and homeowner’s insurance, except we are including private mortgage insurance at $62/month. With the removal of PMI through refinancing, you would save $62 per month and lock in a lower interest rate.
It might not seem like much, but if you have 25 years left on the new loan (300 months), $62 * 300 = $18,600. Those are great savings!
How long will it take to pay off the closing costs?
Refinancing a property isn’t free. Expect to pay 2-5% of the total mortgage in closing costs.
Depending on how large your loan is, these costs can amount to many thousands of dollars. Your goal as an investor should be to figure out how long it will take for the extra margins gained from lower rates and waived payments to surpass closing costs and begin creating profit. However, this question is contingent on what your plans are for the property.
Let’s say you plan on holding a 15-year mortgage until it’s totally paid off. Refinancing makes tons of sense because you’ll easily clear the initial closing costs and fees with the lower payments you’ll make each month. But, if you get that same mortgage and plan on selling the property in a couple of years, then suddenly it may not make sense to refinance. Why refinance when you won’t hold the property long enough to reap the benefits of a lower interest rate?
The easiest way to calculate whether it makes sense to refinance is a break-even analysis. You can find advanced calculators online or use a spreadsheet, but you can just make a simple estimate by dividing the total amount you paid in closing costs by the new savings each month. For example, $2,000 / $100 = 20 months.
Overall, you want to find out how long it will take to recoup your refinance costs after switching to new payments. While this is just one step of the puzzle, it’s a crucial one in determining whether to refinance. The next step is understanding how points (or discount points) will affect your bottom line.
The question of points when refinancing a rental property once again boils down to your goals for each property. Just like closing costs, you’ll want to assess what the future looks like.
Does buying points help your bottom line?
If you hold on to a mortgage for a long enough period, then it makes sense to buy points to lower interest. Each point you buy costs 1% of the total mortgage, so if you have a $100,000 mortgage, you’ll pay $1,000 for each. Every time you do this, you generally will reduce interest by .25%.
This is where it gets interesting. Depending on your goal, buying the interest down will make sense if you plan to hold it for a long time.
For example, if you refinance and get a new 15-year loan with 3.5% interest on a $200,000 home, your monthly payment will be $1,429.77/month.
But if you spend $4,000 for two points, you will reduce interest to 3%, which means your payments will become $1,381.16/month, a savings of $48.61 each month.
It may not seem like a lot, but just like the PMI, these margins add up over time. For $4,000, you reduce the total interest on your loan from $57,358 to $48,609, saving $8,749 and more than doubling your initial point investment. But that’s if you hold the investment for 15 years. What happens if you wind up selling in five years?
By year five, you would have paid $25,904 in total interest on the 3% rate, or about half of the interest for the total period. If you didn’t buy points and kept the 3.5% rate, you would have paid $30,372 in the same period. This results in less equity, but interestingly enough, not as much as you would imagine.
After five years, your loan balance would equal $144,587 with a 3.5% interest rate. At the 3% rate, you would have $143,036 left to pay, just over $1,500 less than the other package.
So, the question becomes, does it make sense to spend $4,000 up front in order to have an extra $1,500 in equity and a little bit extra in cash flow each month if I sell my property within five years? Or should I simply take the extra interest, save my liquid cash for improvements (also tax deductible), and attempt to increase the value of the home to create more equity and offset the interest?
Taxes are complicated, but as you know, there are tons of different tax breaks and deductions you can take advantage of in real estate. When refinancing a rental property, in particular, there are a few things to consider.
For the most part, investment income made by rentals is treated by the IRS as business income. Like other businesses, a rental property will generate income, but will also come with other expenses, such as any property taxes, depreciation, repairs, insurance, and more. Businesses can deduct expenses like these, so you can too as an investor.
When you refinance a property, you’re lowering your interest payment, which means you can’t deduct as much on your taxes. Even if you take out a loan that surpasses the value of the property, the excess cash generally cannot be considered deductible after paying the interest. That means you could spend one to two years looking for other ways to lower your tax bill (like using the extra cash for improvements and claiming that deduction when you file) until you can start deducting interest.
When it comes to closing costs, rentals actually get more leverage in what can be deducted compared to primary residences. The catch is that you have to spread these deductions over the course of your loan. Some of the deductions are attorney fees, inspections, appraisals, insurance costs, recording fees, and more.
On top of that, all points are deductible. So earlier, when in the discussion on the merits of buying points, you would be able to deduct the $4,000 from your taxes after refinancing; on a 15-year loan, that’s a little over $265 you can deduct each year. For all other closing expenses, the same applies. If you spent $5,000 in various costs to refinance, you would deduct about $330 each year.
There are a lot of considerations when refinancing an investment property. This article didn’t cover everything, most notably cash-out refinancing. But it should give you a good idea of what happens during a refinance and whether it makes sense for you to pursue one.
As an investor, your focus should be ensuring you’re going to break even at some point after paying refinance costs. A lower interest rate doesn’t tell the full story, so be sure you’re making calculations and consulting with professionals before making big moves you might be uncertain about.
What are your most important considerations when refinancing?
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