The average rate on a 30-year fixed-rate mortgage has climbed two full percentage points since the beginning of the year, from 3.27 percent to close to 5.5 percent as of mid-May.
While that may seem high compared to the recent all-time low of 2.65 percent, it is still well below the average figure since 1971, of 7.78 percent (to say nothing of the highest annual average rate recorded, 16.63 percent, in 1981).
Borrowers went to their loan officers in droves when rates were at once-in-a-lifetime lows; refinance activity spiked by more than 250 percent. The Wall Street Journal reported that American households saved $5.3 billion by refinancing between January and October of 2020.
Rush to refinance has slowed
As rates have risen, there has been much talk about refinance activity drying up, and not for no reason. For a rate-driven refinance to pay off, a borrower generally needs to cut about 0.75 percent off the interest rate.
With interest rates at 5.5 percent, according to the data analytics company Black Knight, fewer than a million homeowners would be eligible to save money through a refinance. (The firm defines eligible as having a 720 credit score, 20 percent equity, and the ability to trim at least 0.75 percent from their interest rate by refinancing into a 30-year fixed mortgage.)
Lawrence Yun, chief economist for the National Association of Realtors, predicted in late April that rates would stabilize at about 5.5 percent, given that the market has already factored in possible future Fed rate hikes.
Not all refinances are for a rate or term reduction. Many borrowers have record-high levels of equity built up during the historic increase in home prices during the pandemic. For them, a cash-out refinance is a way to tap into that equity to invest in other properties.
In fact, in early 2021, cash-out refinances made up about 14 percent of all loan originations, said CoreLogic Principal Economist Molly Boesel in a recent podcast. As of April 2022, they were about 25 percent.
Other incentives for refinancing
Investors who own several properties may be excellent candidates for refinancing in the current environment.
“There can be portfolio restructuring, especially for investors who own between 5 and 10 properties,” says Dennis Bron, Mynd’s VP of Growth. “It might make sense for them to refinance some of those properties with portfolio loans so that they can continue to buy with conforming loans.
“They could take out a second lien mortgage to fund improvements, and then refinance that back into the loan with a new appraisal.”
Those whose financial position has improved may find it worthwhile to refinance to a loan with a shorter term.
“If you’re in a home that you’ve owned for a while, and your cash flow has increased and you have a ton of equity, it might make sense to refinance to a 15-year loan if you are in a position to pay it off more quickly,” says Bron.
Moreover, if mortgage rates are lower than inflation, there’s still a benefit to borrowing money, because when the borrower pays back the loan, the money paid back decreases in value over the life of the loan as inflation persists.
A cash-out refinance allows investors to expand portfolios
Black Knight estimates that the average homeowner with a mortgage has gained $67,000 in equity since the beginning of the pandemic. This is cash they could access while still retaining 20 percent of the equity in their homes, which is what lenders usually require.
The Federal Reserve estimates that during the pandemic, Americans who own their homes have gained more than $6 trillion in housing wealth. (That estimate doesn’t count equity in rental properties.)
High home values paired with relatively low mortgage rates offers investors the opportunity to draw on the increased value of their homes to expand their portfolios or to make improvements to properties they already own.
For many, a cash-out refinance makes sense.
“They might be willing to pay today’s higher rate, because the cash flow scenario still makes sense,” says Jack Snow, the mortgage program manager at Mynd.
“A lot of clients are letting go of the low interest rates they have to get cash out refinances because of the opportunities that exist,” says Aaron Dounel, a mortgage loan officer with Mynd. “They’re taking on a higher rate, but they’re buying in areas that are going to boom. They’re earning rental income today, and the equity will start building tomorrow.”
The principle of a cash-out refinance is simple: an investor with a loan on a property takes out a new loan of a higher amount, pays off the existing loan, and walks away with the balance as cash.
The investor can use those funds to improve a property, for example by making an addition onto a home, adding an accessory dwelling unit, finishing a basement and renting it separately, upgrading an HVAC system, or replacing aging cabinets and floors.
These improvements can lead to higher rents and improve the home’s resale value.
An entrepreneurial investor could use the cash to expand a portfolio by making a down payment on a new property.
Refinances don’t grow on trees
But there are hurdles to obtaining these loans.
First, it’s harder to qualify. The investor has to have more than 25 percent in home equity as well as good credit, typically a score of 680 or higher, but preferably 740 or above. A borrower usually has to have cash reserves, generally up to a year’s worth of the payments, on the property being refinanced.
Plus, if there are loan balances on properties apart from a primary residence and the property being refinanced, reserves equal to up to six percent of the unpaid balance are required. Finally, there’s a waiting period of six months to refinance after the initial loan closes.
To determine borrowers’ eligibility, lenders use the “loan-to-value” ratio, or LTV, which is determined by the size of the loan as compared to the value of the home.
If an investor is carrying a mortgage of $90,000 on a home that is worth $100,000, for example, the LTV is 90 percent, because the loan makes up 90 percent of the value.
Fannie Mae and Freddie Mac’s guidelines stipulate 70 to 75 percent LTVs. These may be too stringent for some investors seeking a cash-out refinance. Some lenders have more lenient standards, especially after the agency that regulates them placed a tighter cap on the number of investment home mortgages they can purchase.
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