More homeowners are opting for "cash-in" refinancing, a way of improving chances of qualifying for a new loan at a lower rate than the old one. In fact, this can be an excellent investment, beating many stocks and bonds.
Clearly, the purpose of any refinancing is to save money. But what exactly is the return on a cash-in deal?
An analysis by Jack M. Guttentag, emeritus finance professor at The Wharton School, shows that double-digit returns are not hard to achieve.
Freddie Mac (Stock Quote: FRE) recently reported that 22% of refinancings were cash-in deals, in which the homeowner puts extra cash in so that the new loan is smaller than the balance paid off on the old one. In most cases, homeowners do this to meet the tougher standards imposed by lenders after the financial crisis. Most lenders now limit new mortgages to no more than 80% of the home’s current value, while it was easy to obtain most mortgages a few years ago.
Because many homes have lost 20% to 30% of their value in recent years, borrowers wanting to refinance and get today’s rock-bottom interest rates often have to bring extra cash to the table in order to meet the 80% LTV requirement.
The average 30-year fixed-rate mortgage now charges just 4.55%, according to the BankingMyWay survey, compared to 6% a few years back.
There’s a simple way to gauge the benefits of paying down debt: you earn a yield equal to the interest rate on the loan. If you pay off the balance on a credit card that charges 18%, it’s like earning 18% back, because you’re avoiding interest charges at that rate.
But a cash-in mortgage refinancing is more complex. Not only does the extra cash eliminate debt at the old mortgage rate, just like the credit-card payoff, it also produces additional savings by reducing the refinanced balance rate.
By reducing the loan-to-value ratio, the cash-in refi may also eliminate the need to pay mortgage insurance that can generally be charged when the LTV is greater than 80%. Finally, reducing the mortgage rate allows a bigger share of each month’s payment to go to principal. If you sell the house in a few years, you’ll owe the lender less than if you’d financed the same amount at a higher rate.