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November 4, 2002
"What is the best way to
measure the costs and gains from refinancing so I can be sure I will come out
ahead?"
The method I prefer is to compare all costs
of your current mortgage and a new mortgage over a future period. The period
should be your best guess as to how long you will have the new mortgage. If the
total costs are lower with the new mortgage, you should refinance.
This approach is used in calculator 3a, Refinancing
One Mortgage to Lower Costs. It
shows all the costs over a specified period of an existing and a new mortgage
side by side. It also shows the "break-even period", which is the minimum
length of time the borrower must hold the new mortgage to make the refinancing
pay. So even if you are not sure how long you will have the mortgage, if you are
confident that you will have it longer than the break-even period, you know the
refinance pays.
I will illustrate with the case of Jane who
wrote me recently. She had a $320,000 loan balance at 6.25% with 300 months to
go. Her potential new loan was at 5.25% for 30 years, with cash payments of 2
points (2% of the loan balance, or $6400) plus $2200 for other settlement costs.
She guessed she would keep the new mortgage 5 years.
The calculator divided her costs into three
groups:
Upfront costs consisting
of points and settlement costs, were $8600 on the new loan, zero on the old
one.
Monthly payments of principal and
interest were $106,024 on the
new loan and $126,657 on the old one. (These numbers are calculated by
multiplying the monthly payments by 60).
Lost interest
was $7057 on the new loan, $7216 on the old one.
The last item is the interest Jane would have
earned on upfront and monthly payments if she had saved those monies at 2.24%,
her after-tax savings rate. Loan officers sometimes claim that borrowers don�t
understand lost interest. My experience is that most borrowers do understand
that money they spend could have earned interest if they hadn�t spent it. Lost
interest, however, can easily be excluded from the analysis by setting the
savings rate to zero.
The calculator factors in two cost offsets:
Tax savings on interest and points
was $23,469 on the new loan, $25,753 on the old one. Jane�s tax rate of
25.5% was used in this calculation.
Reduction in loan balance was
$25,122 on the new loan, $31,198 on the old one. In both cases, these
were measured from the original balance of $320,000.
Deducting the cost offsets from the costs,
Jane�s new mortgage had a net cost of $73,089 as compared to $76,922 for the
old one. Refinancing would thus save her $3833 over the 5 years. The calculator
also indicated that her break-even period was 39 months.
The fact that this refinancing made Jane
better off doesn�t mean it was the best. For example, Jane could have replaced
the 30-year 5.25% loan with one for 15 years at 5%. Assuming everything else the
same, this shift to a 15-year would increase the net gain from refinancing from
$3833 to $6098, while reducing the break-even period from 39 to 35 months.
Many borrowers who refinance today finance
the upfront costs. They add the costs to the mortgage rather than pay them in
cash. Calculator 3a was recently upgraded to offer a financing option.
Those who try the option find that it reduces
the gains from refinancing. This is largely because the borrower must pay
interest on the costs at the mortgage rate. If Jane had financed the upfront
costs of her new 30-year loan, the net gain from the refinance would have
dropped from $3833 to $1240, while the break-even period would have increased
from 39 to 53 months.
Financing the costs, furthermore, can flip
the loan amount above 80% of property value, which triggers mortgage insurance.
If the borrower is already paying mortgage insurance, it can raise the premium.
If this had happened with Jane�s 30-year loan, the small gain from refinancing
would have become a loss. Fortunately, she had enough equity to avoid mortgage
insurance altogether. The calculator automatically factors mortgage insurance
into the cost calculation, if it arises.
A side benefit from using a calculator is
that it forces borrowers to collect all the information that affects the
profitability of a refinance. Once all the relevant information is at hand, it
is clear that no two cases are exactly alike. Fortunately, the calculator will
handle them all.
Copyright Jack Guttentag 2002
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