Refinancing often seems like a great way to reduce your monthly mortgage payments, leaving you with more money for other things. However, as you weigh the pros and cons of refinancing, don’t forget to consider how the move will affect your net worth in life.
- A simple payback period method is often used to calculate a month when the owner’s cumulative savings exceeds the cost of refinancing.
- A more financially sound way to calculate refinancing costs is to consider the impact on household equity.
- To find out when the refinancing decision becomes economical, homeowners must compare the remaining amortization schedule on their existing mortgage with the amortization schedule on their new mortgage.
Why? A mortgage isn’t just a monthly payment. It’s a debt instrument used to finance assets. Accounting professor’s jargon means that a mortgage will lower your net worth.
The following is the principle of reasoning. A mortgage is a liability on a household’s balance sheet. Therefore, the mortgage loan is subtracted from the household’s assets to determine its equity. Too many consumers fall into refinancing mortgages to lower their monthly payments without considering how refinancing affects their total net worth. Does refinancing your home pay off? Or is this just a short-term fix to a bigger problem?
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Payback period method
The most popular way to determine the economics of mortgage refinancing is to calculate a simple payback period. This formula is built by calculating the sum of monthly payment savings that can be refinanced to a new mortgage at a lower interest rate Loans are realized and determine the months in which the cumulative sum of monthly payment savings is greater than the cost of refinancing.
For example, let’s say you have a $200,000 30-year mortgage. When you take it out, you get a fixed rate of 6.5% and your monthly payment is $1,264. If the current fixed rate is 5.5%, that would reduce your monthly payment to $1,136, saving you $128 a month, or $1,536 a year. The typical rule of thumb is that if you can reduce your current rate by 0.75% to 1% or more, it makes sense to consider refinancing.
Next, you need to ask your new lender to calculate your total closing costs for possible refinancing. For example, if they reach $2300, your payback period will be 1.5 years ($2300 divided by $1524). So if you plan to stay at home for two years or more, refinancing makes sense, at least according to the simple payback period approach.
What the payback period method misses
However, this approach ignores the household balance sheet and total net worth equations. Two main things are unclear.
Primary existing equity balance mortgages and new mortgages are ignored through the simple payback period method. However, refinancing is not free. The cost of refinancing must be paid out of pocket or, in most cases, added to the principal balance of the new mortgage.
When the mortgage balance increases through a refinancing transaction, the liability portion of the household balance sheet increases, and, all other things being equal, the household equity immediately decreases by an amount equal to the cost of refinancing.
Total Mortgage Interest Paid
Just because you get a lower interest rate on your refinances mortgage doesn’t mean you will pay less total interest. For example, refinancing a 30-year mortgage with 25 years remaining into a new 30-year mortgage means you may end up paying more in total interest over the life of the new mortgage. It all depends on how much the new interest rate is lowered.
family net worth law
A more financially sound way to determine to refinance for the economy, incorporating the real cost into the household equity equation, is to compare the rest of the amortization schedule against the new mortgage amortization schedule.
Amortization plans for new mortgages will include refinancing costs on the principal balance. If the cost of refinancing is out-of-pocket, then for a proper comparison, the same dollar amount should be subtracted from the principal balance of the existing mortgage. This is based on the assumption that if the refinancing transaction does not take place, the money you will pay for the cost can be used to repay the principal balance of the existing loan.
The monthly payment savings between the two mortgages is subtracted from the principal balance of the new mortgage. This is done because, in theory, you could use the refinancing generated by your monthly savings to reduce your principal balance on a new mortgage. The month in which the revised principal balance of the new mortgage is less than the principal balance of the existing mortgage is the month in which the true economic refinancing repayment period (based on household equity) is reached.
By the way, amortization calculators can be found on most mortgage-related websites. You can copy and paste the results into a spreadsheet program and perform additional calculations that subtract the difference in monthly payments from the principal balance of the new mortgage.
Examples of Household Equity Method
Using the above calculations, perform a refinance analysis on an existing mortgage with a fixed rate of 7%, 25 years remaining before repayment, and a principal balance of $200,000, converting it to a fixed rate of 6.25% and a refinance cost of $3 of a new 30-year mortgage, 000 (which will be added to the principal balance of the new mortgage) yields the following results:
If a simple payback period analysis were used to determine the economics of refinancing in the example above, the cumulative monthly payment savings would be greater than the $3000 refinancing cost starting in month 19. In other words, the simple repayment period approach tells us that refinancing makes sense if the homeowner wants to have a new mortgage of 19 months or more.
However, with the equity method, the refinancing decision does not make sense until the 29th month, when the principal balance of the new mortgage minus the monthly accumulated payment savings is less than the principal balance of the existing mortgage. The net worth method tells us that it is 10 months longer than the simple payback period method before refinancing becomes economical.
If you refinance your home after it has lost value and have to take out private mortgage insurance, the negative impact on your net worth can be even greater.
special attention items
Keep in mind that in times of declining home values, many homes are appraised for much less than they were before. This could result in you not having enough equity to meet the 20% down payment on a new mortgage, requiring you to come up with a larger cash deposit than expected.
It may also require you to carry private mortgage insurance (PMI), which will ultimately increase your monthly payments. In these cases, your actual savings may not be much, even if interest rates fall.
By calculating the actual economics of your mortgage refinancing, you can determine the exact repayment period you’ll have to contend with. It takes some work to deal with these numbers, but anyone can do it.
Especially if you’re planning to move in the next few years, taking a few minutes to calculate the real economics of refinancing your mortgage could go a long way in helping you avoid losing thousands of dollars in your net worth. If it looks like refinancing will pay off, you’ll have a better idea of exactly when you’ll benefit from the move.