Should You Refinance Now?
Should You Refinance Now?
So, your current rental property loan has an interest rate of 8 percent and you think that you can now refinance your property at 7 percent. How do you decide whether you should refinance now, taking into account loan costs, the income tax considerations, and the time it will take? If it isn’t advisable to refinance at 7 percent, how low of an interest rate is required before you do refinance?
Introduction
Although there can be different factors involved in refinancing your personal residence compared to a rental property, the following analyses apply to either case for most issues.
Is it advantageous to refinance when rates drop by one-percent as many “experts” claim or is some lesser reduction enough or some greater reduction required?
There are several things to keep in mind when hearing that one-percent is the point at which to refinance. First, many of these experts work for mortgage companies and anticipate refinancing income when making the pronouncement. Second, many of those giving such advice do not take into account the income tax ramifications and those affect everyone differently. Third, knowing the rate drop alone is inadequate for making a decision.
Other factors that must affect the decision include the following:
- The cost of refinancing (including your own time).
- Expected future rates and costs.
- Do you want to pull out cash?
- How long you plan to own the property?
- Long-term goals and objectives, such as:
- Do you want to maintain high leverage for maximum return on investment?
- Are you planning to retire in fifteen years and want a free and clear property by then?
- Your marginal income tax bracket (federal, state, and local), both in the near term and in the long term.
Our brief discussion will be divided into two parts – the short-term and the long-term. For short-term we’re most interested in knowing how long it takes for the reduced interest rate to pay the cost of refinancing. This is particularly important when the property might be sold in the near future, as there is usually no advantage to reducing interest costs for less time than it takes to recoup the costs of refinancing. For long-term, we’re interested in knowing the effect over a longer period of many years.
In order to do analyses one must be able to determine the values of various loan parameters for various points in the lives of loans having various interest rates and terms. This can be done by direct calculation, by utilizing printed amortization tables, or by using various computer calculators. The last method is the easiest and calculators are available on many web sites.
Short-Term
In the “old days” when loans could be transferred to a buyer without the lender’s permission, it was usually advantageous to refinance at even a slightly lower interest rate when one planned to sell the property in the near future, particularly if (1) the remaining term of the existing loan was relatively short and/or (2) interest rates were expected to rise by the time the property might be sold. There was the added advantage that it would open the market for your property to those whose financial statement and/or credit rating was significantly worse than your own. This was because the buyer could assume the existing loan or buy the property subject to that loan without the lender’s permission, without qualifying himself. and at little or no cost. The increased value and marketability of a property with the longer term and/or lower interest rate was significantly greater than the refinance costs.
Today, when almost all loans have enforceable due-on-sale clauses, a buyer assuming an existing loan can expect that the lender will want to adjust the interest rate as well as require loan fees, qualification of the buyer, and maybe even require a new appraisal. In other words, transferring an existing loan to the new buyer is sometimes just as hard and costly, or more so, as the buyer obtaining a new loan. Accordingly, the advantage of a lower rate existing loan is usually negligible or none at all.
So, now the only reason to refinance is because it will save you money during the period of ownership.
Unless interest rates have fallen quite substantially below the rate of your current loan, a first consideration is how long you expect to own the property. This is because you want the savings in interest paid during the remaining period of ownership to at least cover the costs of refinancing. In fact, you probably wouldn’t bother to refinance unless you were going to be significantly ahead of the game, since there is time and effort involved.
Long-Term
If you plan to own the property a long time, the number of months required to pay the costs of refinancing is usually of only secondary importance. Whether it requires 13 months or 33 months is not really as important as what the savings will be over a period of many years.
Summary
The analyses you undertake prior to deciding whether or not to refinance can be simple or complex. The complexity of the analyses depends on many factors. In future articles we will first look further at the basic principles involved in determining the time required to pay the costs of refinancing a property and work through an example analysis to demonstrate those principles.
Additional Information
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