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4 Reasons Why the Time to Refinance is Now

Working from home was once considered the exception to the rule, and for many, an option that was considered a privilege. But this is no longer true.

The 20th century brought about what would become the modern office. In fact, many of the inventions – from the telephone to public transportation to the typewriter and the availability of public electricity, were the precursors supporting the current remote work trend. In fact, the. United States Census revealed that between the years 2,000 and 2,010, those employees who worked at least one day each week from home increased by 35% – nearing 13.5 million over the first decade of the 21st century.

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Bet you won’t be surprised to find out which days of the week most workers work from home during that time period-

While remote work as a business model has been gaining strength over the recent past, the coronavirus pandemic only accelerated the already existing telecommuting trend because –

  • Many workers prefer the free time (for family and other personal pursuits) created without the need for a commute.
  • Technological advances have made remote work not only possible but efficient.

Most older homes were constructed without office design features, except for a converted spare bedroom or a partial room in the basement of a split-level. So, for many homeowners who now are working from home, it is likely that some renovations or improvements will be required to create a digitally wired, well-lit workspace that is conducive to productivity and privacy.

Cash-out Refinancing to Fund Home Improvements and Renovations

Refinancing one’s current mortgage to pull out additional funds that can be used to cover renovation or a children’s education costs has been a homeowner’s go-to play for decades. And while cash-out mortgage refinance offers a low-interest rate alternative with reasonable monthly payment terms, there are certain aspects of refinancing that require borrowers to tread with caution as they approach this financing option.

 

Before making a final financial decision to use a cash-out renovation loan, it is essential to be aware of the financing options’ advantages plus potential disadvantages.

Reason 1

The Pros of Using a Cash-Out Refinancing to Renovate

As noted above, mortgage refinance rates are typically some of the lowest available consumer interest rates available, blowing past the higher interest rates charged on personal loans or credit cards. Payments for mortgage loans tend to be most affordable because the payment terms are calculated in decades rather than years or months, which would, given a 30-year payout, create the lowest of all terms, given all other loan terms remain the same. Here is a graph that illustrates the payment paths on a chart for 15-, 20- and 30-year loans.

But note that 15-year loans tend to have interest rates that fall below their 20- and 30-year counterpart mortgages.

Do Not Overlook Potential Cash-Out Refinancing Issues

Closing a refinance mortgage costs money. While much (or all) of the closing costs may be included in the new mortgage amount (if your equity position allows), the reality is, the expenses exist whether they have been financed. At the very least, a borrower should remain in their property long enough to recoup the closing costs associated with a cash-out refinance.

Secondly, your equity position in the property will determine the cash available. And this larger revised mortgage amount is likely to be larger than your original loan amount. Finally, if your mortgage loan is nearing the end of the mortgage term, by refinancing, you restart your mortgage loan to term to the selected new mortgage.

Reason 2

Mortgage Interest Rates are at Historic/Never Before Seen Levels

With interest rates defying the odds of a pandemic and incredible levels of social unrest, they have fallen to historic lows – essentially free-falling since its high in the early 1980s through today’s lows of about 2.9% (30-year national average) or 2.58% (15 years fixed national average – August 17, 2021)

Reason 3

You May be Able to Pull Out Equity with Little Monthly Payment Increases, if any

Refinancing your existing mortgage (with the intention of replacing it with a new larger mortgage) to finance a renovation may provide you with your required funds with little change to a monthly payment or even a lowered monthly payment. This will ultimately depend on the status and terms of the mortgage loan you wish to refinance. An example will help clarify this important issue –

Let’s assume these are the details of your current existing mortgage loan –

  • Current Balance $101,000 – the original loan was $150,000 with a purchase price in 2009 of $200,000.
  • Remaining Term – 18 years of a 30-year loan.
  • Interest Rate – 5.5%.
  • Monthly Payment -$ 851.68

Today, your home has appreciated to $ 350,000, which clearly offers you enough available equity – most lenders allow for up to 80% of the appraised value of a home. In this case, the available equity in the property would be equal to $280,000, or 80% of $350K.

If your goal is to extract about $50,000 to renovate a portion of your home to function as your new home office, you would need to apply for a new mortgage equal to the sum of $50,000 + $101,000 + Closing Costs, as follows –

  • New Loan Amount – $160,000, as an approximate starting point.
  • 30 Year Interest Rate – 3% – with a monthly payment of $ 674.57

At first glance, this proposed savings seems almost too good to be true; that you can take out a new $160,000 mortgage and put about $55,000 to $60,000 dollars in your pocket for a monthly payment nearly 20% less than your current payment.

This apparent good fortune is really the result of two improved financial factors with comparing your old and proposed mortgage.

  • First, the mortgage rate between the two loans has dropped from 5.5% to 3%, which is 2.5% lower. The power of this interest rate reduction is more evident when one considers that the interest rate savings is equal to more than a 45% drop in the interest rate – here’s the math – (5.5% – 3% = 2.5 and 2.5/5.5 = 45.45%).

Consider this example that compares apples with apples –

The differing interest cost for $101,000 at 5.5% each year vs. the cost of $101,000 at 3% per year equals 2.5% * $101,000 – $2,525 – which is equivalent to the interest savings on the existing loan per year – or more than $200 per month.

A significant reduction in the mortgage interest rate on a loan that equals hundreds of thousands of dollars will have a considerable impact!

  • However, another driving savings force with regard to this cash-out refinance scenarios is that the borrower has extended the payment term from 18 years (see above) to 30 years. This results in a bit of a two-edged sword because the monthly payment is lower than the cost of the loan (when all is said and done), will include twelve years (or 144 payments more than your original loan). The math is as follows-
  • The cost of the remaining original mortgage
    • $851.68 * 18 *12 = $183,962.88.
  • The Cost of proposed cash-out refinance
    • $674.57 * 360 = $242,845.20

The difference between the two mortgage totals is $242,845 – $183,962 – $58,882.32 – BUT REMEMBER, MOST OF THIS WAS PULLED OUT AS CASH!

Want to run some of your scenario’s numbers? Try this online refinance calculator to help determine rates, terms, and available cash-out amounts.

Reason 4

You May Be Able to Pick Up a Larger Tax Write Off

The IRS provides for a legitimate home office deduction if the borrower/home office worker meets the IRS’ requirements. To be eligible for the IRS home office deduction, you must meet these requirements –

  • A portion of your home is used regularly and exclusive and exclusive for home office work.
  • A portion of your home is the business’s primary location to conduct business.

If your home office happens to qualify for the IRS deduction, here is a partial list of items that can be legitimately deducted –

  • A one-time material expense for those materials that are required to build/furnish a home office, which does not include the costs of labor.
  • Homeowners are allowed to deduct the total of the yearly mortgage interest paid, the property taxes for the year in question, allowable depreciation, and insurance premiums (for the next year) – all prorated in accordance with IRA rules that determine the percentage of your home that meets the IRS definition of a home office.

Additional Considerations for Cash-Out Refinances for Renovations

Even with ample equity, homeowners and borrowers must meet additional underwriting requirements when choosing to apply for a mortgage refinance.

Credit Score Requirements

Although minimum credit scores vary by lender, program, occupancy status, and property type, most will require a score in the low to mid 600s unless the refinance is through a government agency like the FHA or VA.

Equity Requirements

Cash-out refinances limit the amount of cash based on the available equity in your property. Available equity is a simple calculation that determines the difference between a property’s market value and its current liens.

Here is a quick example with a conventional loan. Your home appraises for $300,000 and you owe, $101,000. The available equity would be equal to $300,000 * 80% (the maximum for conventional loans) = $240,000 – $101,000 = $139,000.

FHA loans allow borrowers to extract up to 85% of the property’s value, which can be helpful if you are short on equity, and VA loans allow for up to 100% of equity if all other requirements are met.

Debt-To-Income Ratio (DTI) Requirements

The DTI – Debt-to-Income ratio is a mathematical calculation that is used to determine how much of your total income is required to cover your monthly housing expenses (known as the 1st or Front Ratio) and how much of your total income is required to cover all of your monthly expenses (known as the 2nd or Back Ratio). Debt ratios vary, depending on the lender, the quality of the refinance deal, the Loan-to-Value, and other compensating factors. But it is safe to shoot for a DTI that is below 46 to 50% for good credit borrowers.

The Take-Away

Your home is a great tool to use for collateral when borrowing equity/money for legitimate purposes – like a renovation, an education, or an upgrade, among others. Intelligent choices for renovations can even help to increase the value of your home while creating a functional space from which to work. But, because it collateralizes your property, if you default on the mortgage, your home could fall into foreclosure and be lost to an auction sale for nonpayment.

Speak with a mortgage representative who can help sort out your financing options and clarify how a cash-out refinance may help you meet your home office renovation objectives. While refinancing with historic lows makes financial and fiscal sense, everyone homeowner and borrower is different and would benefit from a free consultation.

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