Cash-in refinancing means putting cash into a transaction by paying down the balance, as opposed to cash-out refinancing where you take cash out by increasing the balance. Cash-in refinance has become a hot topic recently because in the current market, it is possible for mortgage borrowers to earn a very attractive rate of return on money invested in a balance pay-down, at the same time that the returns available on other low-risk investments, such as Government securities, CDs and money market funds, are lower than they have been at any time since the 1930s.

 Cash-in Refinance in the Current Economic Environment

The high returns available from cash-in refinancing reflect several features of the current financial scene. Interest rates on very low-risk mortgages have never been lower, creating large spreads between those rates and the rates now being paid by millions of borrowers on their existing loans. The problem is that the lowest rates on new mortgages are available only to borrowers who meet the risk requirements, which most do not. These requirements include not only good credit and adequate income, but homeowner equity of 20-25%, which translates into loan-to-value ratios (LTVs) of 75-80% on new loans. Many homeowners cannot meet the LTV requirement because of the decline in home prices that has occurred over the last 4 years. Further, mortgage insurance premiums on loans with LTVs above 80% have increased significantly for those without the very best credit.  

Cash-in refinancing makes the best rates available to borrowers who would otherwise qualify for them but don’t have enough equity in their property. Paying down the loan balance reduces the LTV on the new loan, which reduces the interest rate, mortgage insurance premium or both. The balance pay-down and the lower interest rate it makes possible reduces both the monthly payment over the period the borrower expects to be in the house, and the balance that has to be paid off at the end of the period.

 Calculating the Rate of Return on Investment in Balance Pay-down

The principal question the borrower should ask is whether the rate of return on the money used to pay down the balance and cover the closing costs on the new loan exceeds the return on alternative investments available to the borrower. With Chuck Freedenberg, I developed a new calculator that shows the rate of return on an investment in a loan pay-down in connection with a refinance. It is Mortgage Cash-in Refinance Calculator 3f .   

Here is an example: John has a 6% mortgage with 300 months to go and a $100,000 balance, but his house is worth only $100,000, which makes him ineligible for a refinance. However, if he pays down the balance to $80,000, he can refinance into a 4.5% loan with closing costs of 2%. If he stays in the house for 5 years, the rate of return on his investment, consisting of $20,000 in balance pay-down plus $1600 in closing costs, would be 9.98%. The return is riskless to the borrower.

The rate of return depends on the size of the rate reduction, closing costs on the new loan, how much must be invested to get to an 80% LTV, and on how long the borrower expects to have the mortgage. To illustrate: if John’s house is worth $118,000 rather than $100,000 so that he has to invest only $5600 to get to an 80% LTV, his return would jump from 9.98% to 21.09%. If the new rate is 5.25% rather than 4.5%, the return would fall from 21.09% to 10.41%. If closing costs are 1% rather than 2%, the return would rise from 10.41% to 15.13%. And if John sells the house after only 2 years instead of 5, his return would fall from 15.13% to 9.45%. You can find the returns applicable to your deal using calculator 3f.

 Rate of Return Relative to a Refinance Without Paydown

Readers who use 3f will notice that it calculates two rates of return. The numbers cited above compare the paid-down mortgage with the current mortgage. The second return compares the paid-down mortgage with a new mortgage that does not have a pay-down, and therefore will carry either a higher rate or a mortgage insurance premium. The second rate of return is for borrowers who can refinance profitably without a pay-down, and are therefore not quite sure they want to invest the money in making the refinance more attractive. The return relative to the refinanced loan without a pay-down will be lower.

Suppose John’s house in the example above is worth $111,200, so that his current balance of $100,000 is 90% of value. In this situation, he can refinance without a pay-down by paying mortgage insurance, which I priced at $52 a month. Assuming a rate of 4.75% and closing costs of 1% with or without the pay-down, the returns over 5 years on an investment in pay-down are 14.06% relative to the current mortgage, and 10.75% relative to a refinance without pay-down. Note that if the return relative to a new loan without pay-down is higher, it means that a refinance without a pay-down is a loser and should be avoided. You can check this using my Mortgage Refinance Calculator 3a.