Landlords Deciding If Refinancing Is Beneficial -Part 1
Deciding If Refinancing Is Beneficial – Part 1
So, your current loan has an interest rate of 7.5 percent and you think that you can now refinance your property at 6.25 percent. Should you refinance now? How does one decide when it’s time to consider refinancing, knowing one must take into account the points and other loan costs and the tax considerations? If it isn’t advisable to refinance at 6.25 percent, how much below the old interest rate must rates fall before it’s beneficial to refinance?
Although there can be different factors involved in refinancing your personal residence compared to a rental property, the discussions and analyses in this series 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?
These days, property owners are often bombarded by advertising urging them to refinance their property or take out an equity line of credit or equity loan. The advertising is on millions of Web pages, in the newspaper, flyers delivered to your door, and mail in your mail box. The advertising often fails to provide adequate disclosures, is sometimes downright misleading and, even when adequate disclosures are provided, it’s in less than “fine” print.
When hearing from the “experts” that one-percent is the point at which to refinance, keep in mind the following two important basic points:
- First, most of these “experts” work for banks or mortgage companies and anticipate refinancing income when making the pronouncement.
- Second, knowing the rate drop alone is usually seriously inadequate for making a decision and most of those giving such advice do not take into account many of the various factors that should be considered, including some that affect each borrower differently.
In this first part of the series we’ll mention some of the basic factors related to refinancing. In future parts of the series we’ll delve into ways to perform detailed analyses that take into account some of the factors. One will not usually need to do such detailed analyses, particularly for 1 to 4 unit properties, where the amounts involved are relatively small. Furthermore, there are numerous short-cut methods that provide adequate results for such loans. Although the detailed procedures shown are not often necessary, investors in larger properties may save significant amounts by utilizing the procedures and it is instructive for investors in smaller properties to understand the issues involved.
The Basics
Factors that should be considered when deciding whether it is beneficial to refinance include the following:
- The real total cost of the potential refinancing including your time and that of any others involved.
- Expected future rates and costs compared to at present.
- Your current marginal income tax bracket and what it is expected to be over the term of the loan.
- Whether or not you want to pull out cash.
- How long you plan to own the property.
- Whether or not you might want to do a Section 1031 exchange in the near future.
- Long-term goals and objectives, such as:
- Whether you prefer high leverage for maximum return on investment or low leverage for more cash flow.
- Whether you want to pay off the loan by a particular date because of retirement plans or for other reasons.
Discussions can be divided into two parts – the short-term and the long-term. For the short-term, we’re usually most interested in knowing how long it takes for the reduced interest rate to pay the costs of refinancing, including the time and trouble required to obtain the new loan. 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 the long-term, we’re usually more interested in knowing the effect over a period of many years. It can often be of benefit to pay some additional cost up front in order to obtain significant savings over a number of years.
In order to do analyses similar to those that follow, 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.
Over the past half-century, real estate long-term loan interest rates have varied widely, from a low of around 4 percent, even lower for owner-occupied single-family residences, to a high of about 18 percent, even higher for less than prime properties. Although for much of the past decade rates have been lower, we will use rates in the 7 to 8 percent range in most of our examples because this is probably close to the average of rates for typical residential and commercial rental properties over the five decades.
Loan Type Considerations
There are basically two types of interest rates – fixed and adjustable (ARMs). Although we think that advantages and disadvantages of each of the two types are known to most readers, we will briefly review the two types.
Fixed Rate
A fixed rate mortgage is one in which the interest remains the same for the term of the loan. It could be a short-term interest-only loan with the entire principle due at the end of the term (a balloon note) or an amortizing long-term loan where each payment includes the interest due and some amount on the principal.
It is impossible for a lender to predict where interest rates will be 10, 20 or 30 years from now, so lenders are likely to quote higher interest rates for a fixed rate long-term mortgage to offset the risk to the lender.
While various other costs can vary among lenders, the variances of those items are insignificant compared to the two most important issues in a fixed rate loan – points and interest rate.
Points and interest rate are intertwined. Accordingly, it is possible to minimize the points with a higher interest rate or reduce the interest rate by paying more points (buy down the interest rate). The benefit of one or the other depends on the borrower’s cash availability and the expected period of the loan.
The payment amount for an amortized fixed interest loan is the same for each period, usually one month.
Adjustable Rate Mortgages (ARMs)
Adjustable Rate Mortgages (ARMs) have interest rates that are tied to some kind of financial index. This results in mortgage interest rates that can vary over a specified range. A portion of the long-term rate risk is transferred to the buyer so the lender is willing to accept lower initial interest rates on the loan. Usually, mortgage payments are adjusted as well, but not for all types of ARMs. In any event, the due date of the loan usually remains the same, meaning the loan is not fully amortized for all types.
The various indices used include U.S. Treasury Bills (T-bills), Certificates of Deposit (CDs), London Interbank Offered Rate Index (LIBOR), and Eleventh District Cost of Funds Index (COFI). Each of these indexes has different ranges and rates of potential movement and vary with different aspects of the economy and world events.
Because the lender’s risk is less, interest rates are lower for ARMs than for fixed rate mortgages.
There are essentially infinite potential varieties of ARMs, with more features and options, and a number of additional terms than associated with fixed rate loans. The initial interest rate of the mortgage is known as the “start rate”, applicable for a specific period determined by the terms of the mortgage. The period of time that the rate is fixed can range from one month to several years. Once this initial period expires, the interest rate can begin to vary. The interest rate will rise, fall, or remain the same depending on the long-term rate to which it is tied. The overall change is usually limited annually, and over the life of the loan, by a cap. Typically the annual payment increase cap is several points over the index.
Some adjustable rate mortgages have an annual interest rate adjustment cap instead of a payment cap. That sets a limit on the maximum amount of interest rate adjustment. For example, if the loan has a 2% annual interest rate cap, a loan with a start rate of 8% can then only grow to 10% at the beginning of the second year.
ARMs typically have a lifetime interest rate cap as well, which sets the absolute maximum interest rate allowed for the mortgage. If the financial index to which the interest rate is tied reaches the cap, the mortgage basically becomes a fixed-rate mortgage until the financial index drops enough for the mortgage interest rate to drop below the rate cap. There is usually a minimum interest rate required by the lender as well.
When the interest rate changes without like changes in monthly payments, it is possible for the loan amount to actually increase as the deficit in the payment amount is added to the principal. This is known as negative amortization.
Competition among lenders has resulted in a great many real estate financing options. The fixed-rate mortgage is fairly straightforward and the conservative selection for both borrowers and lenders. Nothing should change during the 15 to 30 year term, except for the property taxes and insurance amount that may be collected in the payment.
ARMs can vary in many different ways and lenders offer a number of different options to deal with changes in the interest rate index. In addition to an annual rate adjustment, some lenders offer a fixed rate for a specified period of time, like five to seven years. At the end of that initial period the rate can vary annually.
Unlike fixed rate mortgages, most ARMs are assumable. That can be a benefit to your future buyer. However, assumption usually requires financial qualification and can also require payment of fees. It is often more desirable to obtain a new loan rather than to assume an existing one.
Choosing between a fixed and variable/adjustable rate mortgage can be difficult and depends on both your expectations for the future of interest rates and your investment comfort level. If security and predictability are most important to you, then the security of a fixed payment long-term loan will be attractive. If you expect to sell within the next five years or are willing to gamble that interest rates will go down or at least remain stable, the variable/adjustable rate mortgage could be a much better deal.
In order to keep the complexity of the analyses that will be studied in future parts manageable, those analyses will only consider fixed interest rates. However, analysis for a variable rate loan is easily performed by breaking the period of time for which an analysis is desired into smaller periods during which the rate is constant.