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Refinancing Strategies
For The Real Estate Investor
Allan Beraquit - December 2004
Should I
or shouldn’t I?
There are many reasons why individuals consider refinancing. The age-old
rule of saving 2% on
rate is
outdated and
can be highly inaccurate. Instead, a borrower's personal & business
financial goals and projected length of ownership of a home, should dictate
if refinancing is a prudent financial decision.
These money
saving and earning strategies will take many pages to explain. Most readers
will fall asleep before they get through the second page.
With that said I'll keep it simple and
use hypothetical scenarios to explain some of the money earning and money
saving techniques employed through refinancing a mortgage.
Section I will cover concepts pertaining to a “Typical Homeowner” and
Section II will discuss concepts pertaining to the “Real Estate
Investor”. In order to avoid duplicating information and to minimize web
content, Section II will add to the content contained in Section I,
therefore it is important Real Estate Investors read both sections.
Please make a selection
Section I - Refinancing for the typical
Homeowner:
Section II - Refinancing for the Real
Estate Investor:
Rate
& Term Refinance
Do I consider
the typical 30-yr mortgage or should I entertain a 15-yr mortgage? If your
intent is to reduce overall interest paid, then a 15-yr mortgage will yield
a slightly lower interest rate than a 30-yr mortgage. For the individual
who owns limited properties, is not concerned with monthly cash flow,
budgeting, future lending continuity and simply has more money than one
knows what to do with, and does not foresee any negative changes in his or
her personal or business financial profile, then a 15-yr mortgage will
save more
interest vs. a
30-yr mortgage. While this holds true; less than 5% of traditional
buyers and
even fewer
Real Estate Investors fit this profile.
Since you can
prepay or pay ahead on a mortgage, why lock yourself into a 15-yr obligation
with a larger payment if you don’t have to?
You don’t have to!
Even with prepayment penalties on certain
mortgages, you are allowed to make additional loan payments, up to 20% of
the original loan balance without incurring a penalty. The additional 20%
well exceeds the additional principal payments associated with a 15-yr
mortgage. In other
words,
there are no penalties
for additional payments. * We will always
review your current mortgage note before proceeding forward with a refinance
to identify any potential prepayment penalty.
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Scenario
The
payment on a $100,000 Mortgage for 30 years at a rate of 5.750% is
$583.57.
The payment on a $100,000 mortgage for 15 years at a rate of 5.750% is
$830.41.
The difference in payment is
$246.84.
If you make the scheduled payments on each mortgage, your home will
fully amortize, or in other words, be fully paid off in 30 and 15 years
respectively.
In today’s
world, financial hardships plague most everyone. These times can be the
direct result of
a
growing family, employment changes, personal illness, starting a
business, college tuition, etc., etc., etc. For the Real Estate
Investor you can add; non-collection of rents, unforeseen maintenance
costs, market changes, need for additional investment capital, etc.,
etc.
On a 15-Yr
mortgage, you will be required to pay
$830.41 per month, every single month. Miss a beat, and you’ll pay late
charges and possibly even earn a bad credit rating. It does not matter
if or why you are experiencing hardship. If you miss a payment, you’ll
pay the consequences.
If one
elected a 30-Yr mortgage with a payment of
$583.57 per month, and instead of paying
$583.57, religiously sent
$830.41,
the 30-Yr mortgage then becomes paid off in 15 years.
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The advantages: If you experience hardship or need to free up
additional capital, you can always make the
$583.57
payment. If you know you will have a large expense such as saving for a
down payment on a new car, college tuition payment, etc. due in the near
future, but really cannot afford to budget for the expense, where do you
free up money? You can make the
$583.57
payment and save the difference of
$246.84.
In 12-months, the monthly savings will grow to
$2,962.08 without interest. Tack on interest, and it
will be greater.
Borrowers, whose income is unpredictable, such as those in sales or those
who own their own
business, benefit greatly from this option when they experience bad
months resulting in slow periods in business or sales.
One major
advantage for Real Estate Investors is that you generate a higher level of
profit on your property and your portfolio as a whole.
The disadvantages: The main disadvantage is discipline! If a
borrower had a choice to make a higher 15-Yr payment vs. a lower 30-Yr
payment, most borrowers will choose to make the lower payment. Secondly,
one can procure a slightly lower rate of interest on a 15-yr mortgage, vs. a
30-yr mortgage.
Forgone Interest Strategy: Let’s play financial planner on this
one. (Numbers
are rounded to the nearest dollar for the sake of ease).
Let’s say you decide to take the 30-yr route and make
the $584 payment vs. the $830
payment, the difference being
$247 per month. In the end, you will pay
$210,240
for your home with a 30-yr mortgage and
$149,400 for your home if you elected a 15-yr mortgage. That means you
are saving
$60,840
in interest by choosing a 15-yr mortgage right? Wrong!!
Let’s say
hypothetically, you took that
$247 in savings and religiously deposited it into a
mutual fund or similar investment vehicle that can earn you an annual return
of 12%; or you invested back into your business that in turn, can
earn a return
of 12%
(Reinvestment back in to your business should
earn a
lot more then 12%); or you used it to pay down your credit card
balances that were costing you 12%; or you used it to pay cash
for items normally charged
to your 12% credit cards.
What would
then be the value of the savings after 15 years? The result is
approximately
$126,000!!!
So instead of
paying an additional
$60,840 in interest by electing a 30-yr mortgage, you in essence just
earned
$126,000
on your
savings, resulting in a Net Profit of
$65,160.
All of
this can easily be achieved,
by simply investing the difference, or using the difference to pay down
debt.
But let’s take
it one step further. Since you’ve elected to increase your term to 30-yrs,
you will now have to apply the same forgone interest strategy to the $583.50
per month you will still be paying on your mortgage for another 180 months!
Reverse Forgone Interest.
$584 per month for 180 months, at a rate of 12%,
will grow to
$298.000.
You can earn this by saving the
$584
per month you would no longer be paying if you elected a 15-yr mortgage from
the start. But let’s not forget about the
$126,000 you already earned during the first 15 years. Leave that
account alone, continue to automatically reinvest the dividends, and that
now becomes
$755,900
on the 30th year!
The end result
is; you earn a net amount of
$458,000. Some say, “We’ll now I’ve got to pay taxes
on the
$458,000.
What nonsense! I will personally pay taxes on profit all day long. 70% of
profit is certainly better then 100% of ZERO Profit.
The
general rule simply is,
if you
can earn a higher rate of interest on your money than the rate you will be
paying on a mortgage and you maintain the discipline to actually do it, then
why elect a shorter-term mortgage? Why even put any money as a down payment
on a home? Take the longest term possible, pay the lowest amount per month,
put as little down on a home as possible and INVEST the difference or use it
to PAY OFF DEBT. How about buying Real Estate Investments with your
savings?
Cash Out or Debt Consolidation Refinance
Now, that
we’ve illustrated the power of money & the power of compound interest; what
do we do if we have additional equity in the property? If I can pull my
equity out in the form of cash, should I take it?
Again, we
revert back to the general rule; if you can earn a higher rate of interest
on your money than the rate you will be paying on a mortgage, and you
maintain the discipline to actually do it,
then go
ahead and take it.
Whether
you take the cash and build a pool or make improvements to your home; or
earn 12% in an investment vehicle; or earn 50% by reinvesting the savings
back into your business; or use it to accelerate the payments on 18% charge
cards or a 9% car loan; or buy another Real Estate Property in an
appreciating market and earn thousands on a short-term flip or even more
through long term appreciation; or pay cash for a large ticket item you
would normally finance through a consumer loan company,
it is probably going to yield you more then a 5.750% mortgage described
above, that is most likely tax deductible.
Anyone who is
investing in Real Estate, Securities, or Business Savvy
would probably never invest large sums of
money in a 5.75% vehicle for long periods of time (15-30 years). That in
essence is what you are doing with equity.
Remember; Equity is a form of savings. Most can do allot better with their
money than the current interest rate they will pay on a mortgage.
The Two Percent Rule
It is
simply ridiculous. If you’ve read and understood the above paragraphs,
you’ll understand why I feel so.
Let’s
take for example an individual who has a current mortgage balance of
$100,000 and a rate of 6.5% (Monthly payment of $632.07), whose intention is
to remain in the home until it is completely paid for, eventually passing
the home on to his/her kids.
This
same individual has been paying on the home for a period of 24 months, and
has 336 payments remaining. He/she is considering refinancing his/her
$100,000 debt into a 30-year fixed rate mortgage of 5.750%. That’s only a
difference of ¾ of a percent. His/her new loan amount will increase to
$103,000 to cover closing cost, prepaids, etc. His/her new mortgage payment
will be $601.08. Monthly savings is $30.99.
Under
this scenario, the breakeven point is 96.8 months. 67.2 months if you apply
the concept of forgone interest to the $30.99. If the borrower sells the
property prior to the breakeven point, then the borrower loses
proportionately. But remember, this is a borrower whose intent is to stay
in the home for the duration. If the borrower continued to make the same
$632.07 payment instead of the new $601.08 payment, the borrower will pay
his/her home off after 317 payments vs. the 336 payments he/she has
remaining. That’s a savings of 19 payments or $12,009.33. More with
forgone interest.
Now,
let’s turn the table. Let’s say the same borrower wanted to sell the home
in 2 yrs after his/her children moved on to college. Instead of a 6.5%
rate, he/she currently has a 7.750% rate and you were offering a 5.750%
rate. That’s a savings of 2%
Do
you refinance? No!
Using
the same projected new loan amount of $103,000 and a projected payment of
$601.08, you would save him/her $115.34 per month. The break-even point is
26.01 months. He/she will sell the property in 24 months. Under this
scenario, why refinance with a 2% interest savings?
So as
you see, it is NOT the 2% rule that matters. It is the length of time one
projects to keep the home (Owner occupied or not) offset by the commitment
and discipline to capitalize on forgone interest strategies.
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