Analysis of home mortgage refinancing options

Recently, the time came for me to refinance my house to lock in a longer term interest rate.  I bought my house on a three year interest only adjustable rate mortgage (ARM) and my interest lock was ending so it was time to find another mortgage.  I had entered into the property with 100% financing consisting of an 80% Interest only ARM as the first mortgage and a 20% adjustable HELOC for the 2nd mortgage.  My goal in refinancing was to extend my interest rate lock for at least 5 more years and to consolidate my two mortgages into one, hopefully at a lower rate due to my 75% loan to value ratio.

From the vast pool of mortgage options, I widdled my options down to three that seemed like potential candidates:

1) 5 7/8% 30 year fixed mortgage with amortized payments over 30 years
2) 6 1/8% 30 year fixed mortgage with interest-only option for first 10 years
3) 6 3/8% 5 year ARM with interest-only option and the ability to pull out cash up to 100% of the property value

As an example because it allows fairly round numbers, lets assume the underlying mortgages on the house are $225,000 and the market value for the home is $300,000.  That equates to a 75% LTV (Loan to value) ratio, close enough to my actual numbers.

• The 30 year fixed amortized option would require payments of 1330.96/month. (calculator available here)
• The 30 year fixed, interest only option would require payments of 1148.43/month ((225000 * .06125) /12)
• The 5 year ARM with interest only option would depend on how much money I actually wanted to pull out of the house but, to keep things consistent, would equate to payments of 1195.31/month ((225000 * .06375) /12)

So, the questions I had to ask myself are:

• How much in extra interest am I paying between the two 30 fixed options? 
• Is the extra interest cost per month less than the opportunity cost I’d have with the extra $182.53 a month that I’d have to pay for the amortized option?

The interest only option is costing me an extra 1/4% in interest which, on $225,000 equates to about $47/month.  Is it worth $47 to free up $182.53 per month?  It depends on your cash flow of course. If the $182/month would make a significant difference in your economic life, then perhaps taking the interest only option would be a better choice.  For me though, I could afford the extra $182 each month in an effort to save $47 in pure interest.  The obvious additional benefit is that I’ll be paying down the principal over 30 years with the amortized loan whereas I would not be paying toward the principal at all for the first 10 years on the interest only, then my payments would increase dramatically after 10 years as the remaining 20 years would force me to pay interest and amortize the principal over only the next 20 years instead of 30.

The second question is whether or not the 5 year ARM with a cash out option would be worth it.  Well, the interest rate between the 30 year I/O loan and the 5 year I/O loan with cash out option is 1/4 different as well (6 1/8% and 6 3/8%) so I know, once again, I’d be paying an additional $47/month in interest just on the $225,000.  The benefit of the 5 year cash out loan is that I could pull an additional $75,000 out at the 6 3/8% rate.  The question is, what kind of return would I have to make to justify that extra amount?  The additional $75,000 would cost me about $398/month in additional interest payments.  Is there a reasonably safe investment option that could bring in more than that amount?

There are a few different ideas I had:

1. Invest the money in a mutual fund. 
2. Try to lend the money at a higher rate, probably via a private loan against property
3. Use the additional money to purchase investment property

• Option 1 just comes down to a question of risk.  Is it worth it to you to risk a $400/month payment on whether or not the market rate will outperform your loan’s interest rate?  If you assume you could earn, say, 10% on the money in the market, that would, theoretically come to $625/month in income which would be a fairly good margin on your money.  Even if you think the market will outperform your cost of capital though, you still have to worry about liquidity and cash flow.  Do you have enough cash flow to make the $400/month payment out of your other income and leave the $75000 to grow on its own or are you going to constantly have to sell bits of your stock each month to make the $400 payment?  If you don’t have the cash flow available to let the money grow, you are increasing your dependence on market timing (you would be forced to sell bits of your stock each month/quarter when the price may be a low levels) and will be spending a fair amount in commissions, depending how you handle the transactions.
• Option 2 comes down to risk and liquidity as well.  Are you comfortable loaning money to a stranger, even if it is collateralized against real estate? Do you want to be in the position of having to worry about whether the person you lent the money to will make monthly payments to you and not commit acts that may decrease the value of the property against which you’ve collateralized your loan?  If that kind of question worries you, lending to a private source may not make sense.  Keep in mind you’d probably need to get a return of at least a couple points higher to make it worthwhile, and you may be lending to folks with substandard credit.  Depending on the person you are lending to, the risk may not justify the reward.
• Option 3, investing the money in additional real estate comes down to a question of what kind of time and interest you have in becoming a real estate investor.  In my market, buying a single family residence that will have a positive cash flow as a rental is difficult.  In order to find a property that cash flows, you’d likely have to invest in a multi-family properly such as a duplex, triplex, or small apartment building.  Having $75,000 in cash may be enough to get you into a duplex, but then a portion of your life becomes being a landlord, maintaining the property, and dealing with the financial and risk aspects of being a real estate investor.

The last thing to consider is that if you were to pass on the cash out ARM option and go with the 30 year fixed amortized option, you will be saving 1/2% in interest on your $225,000.  That equates to $80/month in interest that you are saving.  If you were willing to pay $400/month in interest on the $75,000 in cash with the ARM option, you could view it as allowing you to pay up the $480/month for that $75,000 if you could borrow it outside of your 1st mortgage.  $480/month on $75000 equates to just over 7 5/8% interest rate.  Although it is difficult in the current market, you may be able to find a Home Equity Loan or Home Equity Line of Credit (HELOC) at that rate in the future when you have a use for the money. That would save you paying interest on the money now when you may not have an immediate use for it.

In the end, I went with the 30 year amortized option.  It made the most sense for me from a interest-savings and cash flow standpoint.  In the future, I may take out a Home Equity Loan or HELOC to pull additional equity out, but I will have a 30 year fixed 1st mortgage on my house which will allow me to sleep well at night knowing my payments will be fixed for the remainder of the loan, I’ll be making small payments against the principal, and I’ll be able to retain a fair amount of equity in my home which will protect me against market downturns and allow me a vehicle for additional borrowing if I find a just investment in the future.