On a household's balance sheet, a mortgage is a liability and, as such, is subtracted from a household's assets, which include the value of the home, to determine a household's net worth. Too many consumers fall into the trap of refinancing a mortgage in order to lower their monthly payments without considering how that refinancing affects their total net worth.
The Payback Period
The most popular method for determining the economics of mortgage refinancing involves calculating a simple payback period. This equation is made by calculating the sum of the monthly payment savings that can be realized by refinancing into a new mortgage at a lower interest rate and determining the month in which that cumulative sum of monthly payment savings is greater than the costs of refinancing.
For example, if that calculation says that it will take 20 months for the cumulative monthly savings to be greater than the costs of refinancing and the homeowner will hold the new mortgage for a minimum of 20 months, then this method would say that refinancing is an economically wise decision.
Look at the True Costs of Refinancing
A more financially sound way to determine the economics of refinancing that incorporates the true costs of refinancing into the household net worth equation is to compare the remaining amortization schedule of the existing mortgage against the amortization schedule of the new mortgage.
The amortization schedule of the new mortgage will include the costs of refinancing in the principal balance. (If the costs of refinancing will be paid out of pocket, then the same dollar amount should be subtracted from the existing mortgage's principal balance based on the assumption that if the refinance transaction does not take place, those monies could be used to pay down the principal balance of the existing loan.)
Then, subtract the monthly payment savings between the two mortgages from the new mortgage's principal balance. (This is done because, in theory, you could use the monthly savings generated from refinancing to reduce the principal balance of the new mortgage.)
The month in which the modified principal balance of the new mortgage is less than the principal balance of the existing mortgage is the month in which a true economical refinancing payback period based on household net worth has been reached.
Note: Amortization calculators can be found on most mortgage-related websites. You can copy and paste the results into a spreadsheet program and then perform the additional calculation of subtracting the monthly payment differences from the new mortgage's principal balance. (Check out Investopedia's Monthly Mortgage Payment Calculator.)
For example, using the above described calculations, a refinance analysis of an existing fixed-rate mortgage with an interest rate of 7%, 25 years remaining term and a remaining principal balance of $200,000, into a new 30-year mortgage with an interest rate of 6.25% and refinancing costs of $3,000, which will be rolled into the new mortgage's principal balance gives the following results:
If a simple payback period analysis is used to determine the economics of refinancing in the above example, the cumulative monthly payment savings are greater than the $3,000 costs to refinance beginning in month 19, or in other words, the simple payback period method tells us that if the homeowner expects to have the new mortgage for 19 or more months, the refinancing makes sense.
The Bottom Line
By calculating the true economics of refinancing your mortgage, you can accurately determine what real payback period you have to contend with if you choose to refinance your mortgage. Crunching the numbers takes a bit of work, but it's entirely possible for everyone to do. Especially if you are planning on moving in the near future, taking a few minutes to calculate the true economics of refinancing your mortgage may very well help you avoid damaging your net worth by thousands of dollars.
If you have a home and a mortgage, and you are thinking about refinancing, first you must know both what you want out of your new mortgage and what your different options are, so that you can pick the refinancing plan that best fits your needs.
There are many different situations that will make people consider refinancing their mortgage. Some of the most common ones are:
- They have a fixed-rate mortgage with a high interest rate, and they are looking to get a lower interest rate.
- They have an adjustable rate mortgage (ARM) and are looking to get a fixed rate.
- They have two mortgages and would like to consolidate them into one.
- They have a long-term loan and would like a shorter-term loan so they can pay it off and build equity more quickly.
- They have a short-term loan and would like a longer-term loan so as to reduce their monthly payments.
- They want to move from an interest-only mortgage to a loan that pays down the principal.
- They want some extra cash to make a purchase or to pay off other debt.
There are four main mortgage refinancing options available that can meet the needs listed above:
Cash-out or Cash back Refinancing
This plan allows you to refinance your mortgage for more than you currently owe, and the difference . the equity . is converted into cash for the homeowner.
Low Fixed-rate Loan
If you currently have a high fixed-rate mortgage and the rates have dropped due to market conditions, then you may want to refinance to a low fixed-rate loan. Also, if you have an ARM, you might consider this option in order to get the security of a fixed rate. Even if your adjustable rate is low now, it is not guaranteed to remain that way; but if you get a low fixed-rate loan, then you lock that low rate in for the life of the loan. This option is a good choice if you are not planning on moving within the next five years.
Shorter-term Loan
If your main goal is to quickly build up equity and to pay off your mortgage sooner, then the shorter-term loan is probably your best choice. A lot of times, if you refinance to this type of loan, your monthly payments will be higher, but you will pay substantially less interest and your mortgage will be paid off sooner. Also, you would benefit from a larger tax deduction on interest if you move from a 30-year fixed to a 15-year fixed loan. There are some cases, however, in which you may be able to refinance to a shorter-term loan without raising your monthly payment -if you've had your current mortgage for enough years.
Longer-term Loan
If your current monthly payments are higher than is comfortable for your financial situation, then you might want to consider refinancing to a longer-term loan. This will result in a decrease in your monthly payments, since you will have more time to repay the loan.
Examining your current mortgage and knowing how you would like to improve it are the first steps you need to take when starting the refinancing process. Once you know this, you can choose the option that will best help you achieve your goals.
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