Landlords Deciding If Refinancing Is Beneficial – Part 2
Deciding If Refinancing Is Beneficial – Part 2
In Part 1 of this series we covered some basic issues regarding the decision of whether or not to refinance a property. We stated that 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 this article we’ll consider the basics of determining how long it takes for the reduced interest rate to repay the costs of refinancing.
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 almost always significantly greater than the refinance costs.
Today, following various court decisions and legislation almost all loans have enforceable due-on-sale clauses. Thus, 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 the case of certain commercial properties, the lender may even require at least a Phase 1 study. 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.
We will first look at the basic principles involved in determining the time required to pay the costs of refinancing a property without consideration for tax consequences.
As an example, let’s suppose that (1) the original principal balance was $100,000, (2) you have had your existing loan for nearly 10 years now, (3) it is a 30-year amortized loan, and (4) it has a fixed interest rate of 8 percent. Amortization calculations show that (1) the monthly payment of principal and interest (P & I) throughout the loan term is $733.77, or $8,805 annually, and (2) the principal balance after the 120 payment (12th month of 10th year) is approximately $87,724.
Now suppose that you can refinance the $87,724 loan balance at the end of 10 years for 30 years at a fixed interest rate of 7 percent. Amortization calculations show that the monthly payment of principal and interest (P&I) throughout the loan term is $583.64 or $7,004 annually.
It appears that you will be ahead of the game in one year or less if refinance costs are equal to or less than the difference between the $8,805 and $7,004, or $1,801.
Now, assume that you must pay a 1 point loan fee plus appraisal fee, title insurance premium, and miscellaneous other costs that bring the total refinance costs to approximately $2,000. Since the difference in payments for the first 12 months is $1,801, the monthly savings is $150. Thus, it appears that it will take less than 14 months to pay for the refinance costs. After that time, the average monthly savings of $150 must be yours, right?
Not really! A proper analysis must look separately at the principal and interest paid during that eleventh year for the old loan and the first year of the new loan. Amortization calculations show that if the loan were not refinanced, then for the entire eleventh year of the old loan the payment will consist of $1,854 in principal and $6,951 in interest. Calculations show that for the entire 1st year of the new loan the payment will consist of $892 in principal and $6,112 in interest. In both cases, principal repayment is the same as putting money in your own pocket because debt is being reduced, so it is really only the interest difference of only $839, or about $70 per month, that can be applied against the $2,000 cost of refinancing.
So, again assuming that this amount remains constant, it appears to take approximately 28.6 months to pay for the costs. In our example, we have assumed that the interest savings was the same each year. This is not really true because for both the old and new loans, the interest portion of the monthly payment decreases each month, but not at the same rate. It turns out for our case that the interest savings difference also decreases each month. While we could make exact calculations using the exact numbers for each month, we won’t bother to do so. We can instead use the fact that the annual interest savings decrease by about $100 per year, meaning that for the less than 3 years of interest, the average monthly savings is about $62. Accordingly, we see that it will take approximately 32 months’ worth of interest savings to pay the costs of refinancing.
Unfortunately, even this last analysis fails to tell the real story because we must also consider the income tax consequences, unless the borrower is in the zero marginal tax bracket, in which case the last analysis does apply.
As with everything in life that involves money, it is necessary to take income tax implications into consideration. The most basic thing is that something that can be deducted from taxable income doesn’t really cost as much as the check written to pay for it. This is certainly true for interest on loans secured by real estate, where interest is a deduction for not only income property, but also for a personal residence and even a vacation home.
Accordingly, whenever analyzing the benefit of a lower rate loan, you must consider the after-tax numbers rather than the amount of interest included in your payment. To varying degrees, other loan costs must also be analyzed for tax affects. We’ll take a look at some of the tax issues in Part 3.