Loan Refinance
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 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:
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