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. (Find out more about payback periods in Understanding The Time Value Of Money.)
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.
Refinancing Affects Your Household's Net Worth
However, this simple payback period method ignores the household's balance sheet and the total net worth equation.
Two primary things are unaccounted for:
1. The principal balance of the existing mortgage verses the new mortgage is ignored. Refinancing is not free. The costs or refinancing must be paid out of pocket or, in most cases, are rolled into the new mortgage's principal balance. When a mortgage balance increases through a refinance transaction, the liability side of the household balance sheet increases, and all other things being constant, the household net worth immediately decreases by an amount equal to the cost of refinancing.
2. Refinancing a 30-year mortgage with a 25-year remaining term into a new 30-year mortgage means that you might end up paying more total interest over the life of the new mortgage, even though the interest rate on the new mortgage is lower than you would pay over the remaining 25 years of the existing mortgage.
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. (Find out more about amortization in Appreciating Depreciation.)
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.
However, if the net worth approach is used, the refinancing decision would not become economical until month 29, when the principal balance of the new mortgage minus the cumulative monthly payment savings is less than the principal balance of the existing mortgage. The net worth approach tells us that it takes 10 months longer than the simple payback period approach before the refinancing is economical.
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.
To learn more about refinancing and paying your mortgage, see Mortgages: The ABCs Of Refinancing, Seven Common Financial Mistakes and Paying Off Your Mortgage.
By Barry Nielsen, CFA
G. Barry Nielsen is a homeowner with a large household of six children. Nielsen holds the Chartered Financial Analyst (CFA) designation and has worked for several large mortgage lenders and financial institutions, including Freddie Mac, American General, Washington Mutual and Countrywide Home Loans. Nielsen owns and operates MortgageGraphics, Inc., a web-based software tool designed to help consumers make educated, risk-based mortgage decisions.
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