We Locked in at 5% on a Cash-out Refinance and Lost $55,000
Yep, that’s right. We locked in a 5% mortgage rate on a 30 year cash-out refinance on our home. Our goal: to get a lower rate on our home mortgage and pay off as much of our rental property mortgage as possible.
So how’d we lose $55,000? We just got back our home appraisal for the new loan… it came in at $370,000, or $30,000 lower than the $400,000 purchase price from November, 2005. We’ve also put about $25,000 into upgrades in this house, making our total loss that much larger. Even though $55 large is a sizable sum, the loss only represents a depreciation of 13.75%. Overall, that’s not too bad considering the doom and gloom in the housing market. We’re thankful to have a roof over our heads.
Why We Locked in Now at 5.0%…
Our current home mortgage loan is at 5.75%. Our townhome rental property is at 5.625%. I had been tracking rates since mid-December, watching them fluctuate between 4.875% and 5.5%. Right before Christmas, 2008, rates dipped to their lowest point in several years, then moved back to around 5.375% between the holidays, then back down into the high 4s / low 5s in early January, 2009. We snagged 5% on January 9. While I recognize that rates could go even lower in February or March, we are concerned about inflationary pressures and a 5.0% rate represents a significant savings over our current loan structures. Best of all, it meets our payback period expectations.
We were able to get the good rate because we watch our credit report and FICO score like hawks… You never know when a refi. opportunity will present itself, so it’s important to stay on top of both and correct any issues that arise.
Payback Period & Closing Costs
Our home mortgage balance is $240,000. At 5.75%, that makes our total yearly interest cost about $13,800. (Note, that number is an estimate because throughout the year we’ll be chipping away at the principal. But, this is good enough for our purposes). At the new 5.0% rate, our yearly interest would total $12,000, or $1800 less. Since mortgage interest is tax deductible and we’re in the 25% tax bracket, the real after tax savings is 75% of $1800, or $1350. For all intents and purposes, $1350 is our interest savings on our primary home.
Our townhome has a mortgage loan balance of $62,500. Unfortunately, due to our $55K loss on our home appraisal, we’ll only be able to borrow enough to pay down $50,000 of the townhome loan without exceeding an 80% loan-to-value ratio on our own home (this is important because real rates go up substantially over an 80% LTV). $50,000 at 5.625% costs $2813/year in interest. At 5%, the yearly interest cost drops to $2500, for a savings of $313. Again, this interest is tax deductible and we’re in the 25% bracket, so our real savings is 75% of $313, or $235 in interest savings each year on the rental.
So, our total savings from both properties is $1350 + $235 = $1585 / year in interest savings, or roughly $132 / month.
Our total real closing costs are as follows:
- $470 Appraisal & Credit Check Fee
- $19 Flood Life of Loan Fee
- $70 Tax Service Fee
- $575 Underwriting Fee
- $1305 Title Exam, Title Insurance, Attorney’s Fees
- $0 Origination Fee (no origination, although the underwriting fee is comparable)
- $0 Points (no points)
(real closing costs that aren’t prepaid items for things like insurance and property taxes that will be refunded from our escrow on the current loan)
Total Real Closing Costs: $2439.
Payback period is generally considered the number of months it takes to recoup the cost to refinance. To caculate the payback period, divide the total real closing costs ($2439) by the monthly savings ($132) to get the result (18.5 months).
What’s a Good Mortgage Refinance Payback Period?
There’s no hard and fast rule here. A good rule of thumb is to target a payback period no longer than 18-24 months. You should never take a payback period that is longer than the amount of time you plan to stay in the house or keep the loan. Kim and I think we’ll be here for many years to come and probably won’t have thee financial wherewithall to put major dents in the big mortgage, so an 18 month payback period is just peachy for us.
Our Payments Will Temporarily Be Much Larger
One of the downsides of not being able to completely pay off our rental property mortgage is that we’ll continue to make the same size payments on the townhome, although more of that payment will go to principal once we pay off $50,000 on that loan using proceeds from our cash-out refi.
At the same time, our home mortgage payments will be considerably higher because the loan will be drawn for $50,000 more. We considered the impact of this, which is essentially the cost of principal+interest on $50,000. That equates to a higher payment by about $270/month.
Note that even though we’re paying an additional $270/month to make this arrangement work in the short run, this has no effect on our real costs, only how much principal we’re paying against each loan. We were already overpaying by about $300 each month on the principal balances, so we’re used to this cost in our budget.
The Psychological Benefits of Owning a Property Debt Free
One of our primary goals in this refinance is to get our rental property as close to “paid-off” as possible without jeopardizing our cash flow or financial health. This refinance gets us down to $12,500 on our rental property loan and puts us that much closer to the debt-free life we want to live.
Granted, we’re mostly shifting debt from one property to another, but at least we’re getting a lower rate, a relatively short payback period, and the added satisfaction that we’re that much closer to only one monthly bill.
What do you think? Are you on the sidelines for a refinance, or have you already taken the plunge?
Photo by WoodleyWonderWorks (edited under CCL by me to read “5.0″)
Comments & Conversation on this Article...
8 Responses to We Locked in at 5% on a Cash-out Refinance and Lost $55,000
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January 23rd, 2009 11:56 am
Thanks for laying out this complex issue so logically.
January 23rd, 2009 6:39 pm
You wrote:
“….exceeding an 80% loan-to-value ratio on our own home (this is important because real rates go up substantially over an 80% LTV).”
Are banks still offering PMI if you can’t put 20% down?
January 23rd, 2009 7:27 pm
1shotrising: yep – if we took an 83% LTV loan, they wanted $149 in PMI / month. This number is tax deductible, but HUGE… now, you can get that removed once you get down to 80%, but it mucked with our profitability so bad it just didn’t make sense. Another option was to take a second loan. The mortgage co. wanted an extra 1/8 of a point and the second would carry an 8% interest rate. Also not a good option for us.
It used to be real easy to get high LTV loans with reasonable PMI. These days, that’s real hard to do. Some mortgage companies won’t go over 90% total LTV between both loans (or if they will, the PMI costs get prohibitive).
January 26th, 2009 9:57 am
It sucks that you do everything right and you still LOSE money!
I can’t offer any wisdom on refinancing, but I CAN attest to the “psychological benefits of owning a property debt-free.” Even after holding back that extra bit to cover taxes and insurance each month, I now have more money to put back into house projects. (Which is FABULOUS in a year which likely will not see a bonus from work …)
April 14th, 2009 11:33 am
question for you—aren’t you increasing your tax liability by accelerating payoff of your rental property?
if you don’t pay rental loan interest on schedule E then the rent received (after deducting your other expenses and depreciation) will be income, and fully taxed.
April 16th, 2009 8:42 pm
j -
No.
Mortgage interest on a primary residence is deductible as an itemized deduction. There is no difference whether the interest is paid on our primary residence or on a rental.
Fred
June 19th, 2009 10:47 am
You are losing the ability to deduct your interest payments on your rental property once it is paid off. Does not make sense. Also you will be taxed capital gains on the rental property when you sell it, especially if the mortgage is paid off. Are you planning a 1031 exchange once you sell it?
Not sound advice or planning, you are giving away tons of tax money that you could keep in your pocket just for a “physcological benefit”. What good is this benefit if it costs you a bunch of money?
Consult someone with more experience or a reliable financial expert that personally owns rental real estate.
June 21st, 2009 8:56 pm
Greg,
1) We are not losing the ability to deduct the interest payments since interest on our primary mortgage is also deductible, and we essentially refinanced the loan into our primary mortgage. The advantage of refinancing the way we did is to take a lower interest rate on both properties. This reduces our total interest deduction, but only because it also reduces the total interest owed, a very wise investment indeed.
2) Capital gains taxation is completely divorced from whether or not a loan exists on the property and their is no benefit by retaining the loan. Capital gains is calculated by subtracting the cost basis of the property from the sales price. Cost basis is the purchase price + improvement costs less depreciation. Neither sale price nor cost basis is affected by carrying the loan.
3) A 1031, or “like kind exchange” would allow you to avoid capital gains taxation temporarily regardless of whether a loan existed on the property. These topics are fundamentally distinct and shouldn’t be considered together.
1031 transactions are difficult to time and usually require a trustee. For most independent landlords they are a pain to negotiate properly, as you must essentially unload the cash very quickly into a new property. Plus, you are only deferring the gain, not avoiding it completely. There are a number of reasons to attempt it, but they all relate to NPV of the dollar and expected future tax brackets, not the existence of a loan.
As for consulting someone more experienced, I have a MBA in Accounting from a respected institution and have been working tax issues like these for years.
In other words, It’s you that needs to better understand the relevant facts and issues.