Refinance Mortgage to conventional loan to drop PMI

Question

I refinanced my mortgage last year out of pure necessity. I had decided to build a 1 bedroom apartment out of my un-used garage space and the construction costs went way over budget.

To add insult to injury, I got laid off shortly after I finished construction. I lost about 3 months worth of salary, then resumed work only to get in a bad car accident after I got back to work and lost about another 2 months of salary. I was living off of credit cards almost 5 months and now have over $45,000 in consumer debt ($23,000 auto loan and $22,000 in credit cards).

The good news is, work has stabilized. I'm able to rent the new apartment for an average of $1800 / mo. I've got a decent tax return (approx $10,000) and there's a good chance I'll get about $40,000 for "pain and suffering" in an injury case (not a guarantee, but highly likely).

My principle on the house is $285,000. It's a 30-yr Fixed FHA loan at 4.5% (I have some collection items dragging my credit score down (approx $3000 in medical) and a bad debt/income ratio. My average FICO score is about 625.

I spoke with Loan Depot (current mortgage company) about 2 potential refinance programs:

1. 30-yr Conventional @ 4.5% apr, $8,000 cash out, principle increase to $308,000
2. 30-yr FHA @ 4.5% apr, $18,000 cash out, principle increase to $313,000

My main goal is to pay off debt, but I also have other investment projects I want to pursue. One would be adding another apartment to the basement and potentially getting another $1,800 / mo cash flow. This would be about a $30,000 project

Most of my consumer debt is at obscenely high interest rates (15% for the car and 29.9% for most the cards). This bothers me, but not enough alone to refinance again. While my monthly payments on cards is nearly $1000, $500 of that is for short term loans that will be paid off in the next 2-3 months.

My question is, what should I pay first, and how? Should I start the basement apartment construction this spring? Should I apply all/some of my tax return/injury settlement towards credit cards? Should I move to a conventional loan and drop nearly $250 / mo in PMI payments?

Answer 1

I'm going to answer based on my own personal perspective on financial decisions - ultimately, you need to determine your own criteria (risk tolerance, goals, etc) and decide the answers to your questions for yourself.

Personally, I don't think it makes much sense to invest money when you have outstanding high interest debt, because from a pure numbers perspective, it rarely makes sense. Unless your investment has a (literally) guaranteed return which you know will work out to your financial advantage in terms of beating your debt interest, it literally doesn't make sense to invest before paying off your debt. And, to be clear, renovating a basement to convert it into income property is really far from being a guaranteed return. What if the remodel goes way over budget? Or you can't find a tenant? Or your tenant doesn't pay? Or they burn the place down?

So, if we set aside the income property investment for a minute, the thing that makes the most sense for the cash you have now (or will soon get) is to pay down your consumer debt ASAP. This will stop the hemorrhaging in terms of the high interest rates on that debt.

At that point, you may be in a position where refinancing makes sense - either as a way to help fund your other apartment, or purely because it makes sense just in terms of your home. It's "easy" to consider the numbers involved in refinancing, but it's important to also consider the stability of your home's value and the potential for the interest rate available to you, personally in the near future. That last point is important for people with lower credit scores, since getting that score up can have a significant impact on your finances, over time. You're quoting mortgages at 4.5%, the lender I use is currently under 3% for shorter mortgages, and at 3.125% for conventional 30 year fixed mortgages. These rates are for A paper, which means a credit score around or above 700 or so, for most lenders. You're not really that far from being able to qualify for that, in terms of your credit score.

If you can spend the next months focusing on getting your debt paid down, and making sure things are taken care of in terms of your personal finances, you may find that your credit score has increased enough that you can get a much better rate on your mortgage. A 30 year mortgage at 3% for 300,000 has a total cost of 455,332, while the same mortgage but at a 4.5% rate has a total cost of 547,220. You stand to save almost $100,000 over the life of the loan if you can get your finances in order and get yourself into the best rate bucket. Even though your current FHA loan means you're paying PMI, it may make sense to eat that "penalty" for a while in order to get into the best loan possible. Plus, this will give you time to make sure everything in your life truly has stabilized, and it'll give you time to make sure your budget is stable. At the risk of offering unsolicited advice, you've had a lot of change recently, and you've got a lot of moving pieces on the board right now - it may make sense to concentrate on reducing and stabilizing before doing something like another income apartment remodel or a major refinance.

Answer 2

I strongly advise you to reconsider whether this is the right time for you to take on additional debt, even for a worthwhile purpose to earn rental income.

It is highly unlikely that you can achieve higher returns, or lower risk returns, compared to just paying off your credit card and auto loans. If you pay those off even by consolidating at a 4.5% loan, you go from about an average interest rate of 22.5% to 4.5%, which would be savings of 18%, or about $8,100 per year! This would be risk free, because those returns exist whether or not the market goes up or down, or whether or not you can rent your house, or have repair costs, or anything.

Saving $8,100 per year would give you the 30k to upgrade your basement in just 4 years, and you would be in a much more stable position in the meantime. Add in the 10k tax refund this year would save you even more interest and you could get to your basement project that much sooner. It would also give you more experience as a landlord, and you could see some more pitfalls through your current apartment that might help you make that decision for the basement more wisely.