These last 12 months have been some of the most confusing that people have ever experienced. With a regular inundation of both good and bad, positive and negative information, it can be difficult to filter through all the noise and discern what’s right for oneself and one’s family. This is true in a number of areas and can be especially true when it comes to making sound financial decisions in the midst of so much uncertainty.
One of the areas that has been a hot topic the last year has been that of refinancing a home mortgage. If this is not a term you are familiar with, it is essentially taking your existing mortgage, and converting it into a new mortgage. This can be done by lengthening or shortening the number of years left to pay it off, changing your interest rate, and even potentially changing the balance of your current mortgage. The most common scenario is taking your existing terms, leaving the balance the same and reducing your interest rate. This would decrease your monthly payment amount or increase how much of your monthly payment goes towards your principal balance. That means more of that payment is going back into your pocket long-term in the form of equity in your home.
A great reason to refinance is likely the most uncommon, but possibly the most profitable option of all. Imagine with me for a second that you purchased a house for $100,000.00 exactly 10 years ago and you have been paying $800.00 per month ever since. Over the course of the last 10 years, you have paid your mortgage principal balance down by $25,000.00. In addition to that 25K in principal pay down, your house has also appreciated at 4% per year. The new value of the house is just under $150,000.00. This means that your house currently has around $75,000.00 in equity. All that to say, your house currently has a 50% equity position.
Why is this important? Because you essentially have $75,000.00 in a less traditional form of savings account that is not earning you any return. One way to access that equity is by doing what’s called a “CASH OUT REFINANCE.” When doing this type of refi, let’s call it a COR, lenders will refinance your house and give you a new loan and new interest rate for up to 75% of its total appraised value.
So in the example above, 75% of $150,000.00 is $112,500.00. Subtract $75,000 for the remaining mortgage balance from that and you have $37,500.00. Go ahead and reduce by $3,000 to account for some closing costs. This gives you $34,500.00 that you could reinvest somewhere else.
Now, let's say your new mortgage balance of $112,500.00 has a total monthly PITI (principal, interest, taxes, insurance) payment of $900.00. You could take the $34,500.00 that you cashed out, and use it as a down payment for a rental property that rents at $1,100.00 each month. This would be a pretty standard rent for an average 3 bedroom house in the Rio Grande Valley of South Texas, where we live and work. Let's say that particular rental house was purchased for $100,000.00 and you used $20,000.00 for a 20% down payment (the minimum requirement for an investment house) and $5,000.00 for your closing costs. And let's say this mortgage payment has an average monthly PITI charge of $700.00. You now have 2 payments totaling $1,600.00 and you have rent coming in at $1,100.00. So you only have to pay $500.00 per month out of pocket rather than the $800.00 that you were originally paying. You could save that $300.00 every single month and add it to the $9,500.00 you still have left over from your refinance and you will be in a position to do this all again in a few years.
Many people may argue that this is risky and may not be comfortable with the debt load, but I would like to counter that with the following math. On both properties, you still have a 25% equity position. It is unlikely that the real estate market in the valley will decline by 25% so you will probably not be upside down or at risk of losing your properties at any point in time. Each month, you will have roughly $200 per house going towards your principal balance pay down. That’s roughly $5,000.00 per year. In addition to this, you now own $250,000.00 worth of real estate that is appreciating at 4% per year. That’s another $10,000.00 being added to your pocket each year. So by spending $500.00 per month on a mortgage you would have been paying anyway, you are making roughly $9,000.00 per year in the form of appreciation and principal reduction. And to accomplish all of this, it required $0.00 out of your own pocket because you tapped in to the equity you already had in your house.
Imagine what it could look like if you did this every 3-5 years!
