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Mortgage Refinancing:

An Application of Fisher’s Separation Principles

In this exercise, students analyze a borrower’s refinancing decision and recommend the best refinancing strategy. Pedagogically, students apply Irving Fisher’s separation theorem: distinguish rational issues from irrational issues, determine an appropriate cost of capital, and enumerate “beneficial” effects. NPV analysis provides the optimal refinancing solution and demonstrates the beneficial relevance of 1) a new interest rate, 2) expected holding period, and 3) mortgage scale. NPV analysis also demonstrates the beneficial irrelevance of 1) equity build-up, 2) payment scale, 3) total interest expense, and 4) term to maturity.

Introduction

In 1984, 30-year fixed-rate mortgage (FRM) interest rates began a 28-year secular decline (see Figure 1). Each ensuing decade brought lower interest rates and record periods of refinancing. After the 2008 financial collapse, Congress encouraged homeowner refinancing by passing the Home Affordable Refinance Program (HARP) and the Home Affordable Modification Program (HAMP). Then, in July 2011, the Federal Reserve initiated “operation twist.” Its explicit purpose was to lower long-term interest rates even further. By November 2012, FRM rates reached a record low of 3.34%. Throughout this period, borrowers asked “Should I Refinance my mortgage?”

An online article on The Yahoo!-Zillow Real Estate Network in June 2012 declared four reasons for refinancing: 1) lower the interest rate, 2) switch the mortgage type, 3) build home equity faster, and 4) take out cash[i]. When considering refinancing the article advised borrowers to ask:

• How long will I be in my home?

• Is there a prepayment penalty?

• Will tax savings be reduced?

• Can I build equity faster?

• Can I improve the features of my ARM?

• Can I reduce the monthly payments?

• Can I cash out some equity?

|Figure 1 |

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|30-Year FRM, 15-Year FRM Rates 1984 - 2012: |

|[pic] |

|Reproduced with the permission of Mortgage- |

The article concludes that “Refinancing helps many homeowners stay in their homes for less money, or gives them the cash out they desire, but just make sure you do the math and understand how the new loan will affect you.”

Rules of thumb:

So-called “rules of thumb” offer refinancing advice. Always evolving, these rules are shared at coffee breaks and appear in the popular press. Excerpted below is an example from Money Watch entitled “Should You Refinance? The Rule of Thumb has Changed.”

If you gather 'round the water cooler long enough, you'll hear a lot about two things: sex and mortgages. Everyone talks about who they're dating and when they're going to refinance. For either subject, the question being asked these days is when you should actually pull the trigger.

There used to be a rule of thumb that said "Don't refinance unless you could drop the interest rate by 2 percentage points." And that rule of thumb lasted for a long time, until no-point and no-cost refinancings were introduced.

Then, the rule of thumb changed to "Refinance if you can save money within 6 months of refinancing" (many folks were able to save starting the month following the closing). These days, banks are charging astronomical fees for refinancing (hello bank profits!), and there are many people for whom it would take literally 5 to 6 years to pay off the costs of the refinance with their "savings."

Here's my new 2009 rule of thumb: Don't focus solely on how low interest rates are. Instead, take a look at what you'll be saving and how quickly you can pay off the cost of the refinance (or what's left of it) of your loan AND save money each month, that's worth bragging about[ii].

Refinance Calculators:

The internet, of course, is another source of refinancing advice. A Google search of “refinancing advice” yields, literally, millions of sites. In recent years, banks, mortgage brokers, and insurance companies popularized “refinance calculators” on their mortgage websites. The typical calculator asks prospective borrowers for input information on their current and proposed mortgages. Then, based on borrowers’ answers, the refinance calculator generates a refinancing recommendation. Answers are numerous and varied: from dollars saved, to break-even time, to break-even interest rate. A summary of input variables and output results from nine popular refinancing websites appears in Table 1.

Given the varied array of refinancing advice from popular press articles, “rules of thumb,” and refinance calculators, borrowers often find the refinancing decision to be confusing and complicated. They wonder which issue or issues are most important. Should they maximize monthly payment savings, minimize total interest paid, maximize equity build-up, or minimize break-even time? Or, should they consider all solution outputs? Is there not a single goal on which borrowers can focus to make the refinancing decision?

  |  |  |Table 1

Popular Website Mortgage Refinancing Calculators | |  |  | |  |  |  |  |  |  |  |  |  |  |  |  | |  |  |Bank- |Calculators4 |Mortgage |Lending- |  |Mortage |CNN |Realtor |US |  | |  |  |rate |Mortgages |101 |tree |NBER |Calculator |Money |.com |News |  | |  |Input Variables |  |  |  |  |  |  |  |  |  |  | |  |Current interest rate |Π |Π |Π |Π |Π |Π |Π |Π |Π |  | |  |Original loan amount |  |Π |Π |Π | | | | |Π |  | |  |Original loan term |  |Π |  |Π | |Π | | |Π |  | |  |Current monthly pmt |Π |Π |Π |  |  |  |Π |Π |  |  | |  |Mortgage Age |  |Π | | | |Π | | |Π |  | |  |Remaining Balance |Π |Π |Π |Π |Π |Π |Π |Π |Π |  | |  |New interest rate |Π |Π |Π |Π | |Π |Π |Π |Π |  | |  |Remaining term |Π |  |Π |  |Π |Π |Π |  |  |  | |  |New loan term |Π |Π |Π |Π |  |Π |Π |Π |Π |  | |  |Closing costs |Π |Π |Π |Π |Π |Π |Π |Π |Π |  | |  |Points |  |  |Π |Π |Π |Π |Π |Π |Π |  | |  |Pre-payment penalty | |  |  |Π |  |  |  |  |  |  | |  |Cash out |  |Π |  |  |  |  |  |  |  |  | |  |Property Value |  |  |Π |  |  |  |  |  |  |  | |  |Income tax rate |  |  |  |  |Π |Π |  |  |  |  | |  |Discount rate |  |  |  |  |Π |  |  |  |  |  | |  |Inflation rate |  |  |  |  |Π |  |  |  |  |  | |  |mortgage rate volatility |  |  |  |  |Π |  |  |  |  |  | |  |Output Results |  |  |  |  |  |  |  |  |  |  | |  |New monthly payment |Π |Π |Π |Π |  |Π |Π |Π |Π |  | |  |Monthly savings |Π |  |Π |  |  | |Π |Π |Π |  | |  |Interest rate difference |Π |  |  |  |  | |  | |  |  | |  |Total cost |Π |  |  |  |  |Π |Π |Π |  |  | |  |Time to recoup costs |Π |  |Π |  |  |  |Π |Π |Π |  | |  |Total interest payable |  |Π |  |  |  |  |  |Π |  |  | |  |Sum of new payments |  |Π |  |  |  |  |  |  |  |  | |  |Payoff date |  |Π |  |  |  |  |  |  |  |  | |  |Balance at sale |  |  |Π |  |  |  |  |  |  |  | |  |Breakeven time |  |  |  |Π |  |  |  |  |  |  | |  |Breakeven rate |  |  |  |  |Π |  |  |  |  |  | |  |Lost tax savings |  |  |  |  |  |Π |  |  |  |  | |  |Balance change |  |  |  |  |  |Π |  |  |  |  | |  |Refinancing benefit |  |  |  |  |  |Π |  |  |  |  | |  |Total loan costs |  |  |  |  |  | |Π |  |  |  | |  |Compares refi options |  |  |  |  |  |  |Π | |  |  | |  |Total interest savings |  |  |  |  |  |  |  |Π |  |  | |  |Unpaid interest at refi date |  |  |  |  |  |  |  | |Π |  | |  |  |  |  |  |  |  |  |  |  |  |  | |

A Specific Case:

Mid-2002 to mid-2003 was one of many refinancing boon periods that occurred during the long-term secular decline in mortgage interest rates. The Wall Street Journal in July 2003 featured an article in its on-line real estate section about a middle-aged couple trying to decide if refinancing is beneficial. Interest rates had declined from 6.5% to 5.375%[iii]. Refinancing would lower their mortgage payments by $700. However, the couple worried that refinancing would also restart the mortgage payoff-off clock. With a new loan, equity would build-up more slowly, total interest expense would likely increase, and mortgage payments would last an additional eight years. The author responds with his analysis and advice:

When Is Refinancing In Your Best Interest?

By PATRICK BARTA

Special to

Question: My husband and I are currently in the eighth year of a 15-year mortgage. Our monthly payments are approximately $1,700 and we have $131,000 left on our loan. Does it make sense to refinance for another 15 years at 5.375%? It would reduce our payments to $1,100 a month but since we currently pay more principal than interest, we're uncertain which direction to go. We are in our early 50s and our children are both graduating from college this year. Your thoughts, please.

-- Pat, Chicago

Answer: Don't worry about the fact that you're already halfway through the term of your mortgage. There's an easy way to make your refinance make sense: Pay down your loan early.

To illustrate this, consider a hypothetical scenario based loosely on your experience, provided by , the consumer-finance web site. This scenario assumes that you took out a 15-year, $200,000 mortgage at 6.5% interest seven years ago, with a monthly payment of $1,740. The balance on this loan would now be about $130,000 and you would have paid a total of $76,500 in interest. If you keep the loan, you'd wind up paying another $37,100 in interest over the next eight years.

Now, let's say you decide to refinance. Doing so will likely cost you about $3,000 in fees. So whatever you do, you'll want to make sure you save more than $3,000 in interest over the life of your new loan, meaning that you'd want to pay no more than $34,100.

Simply refinancing into another 15-year loan (at today's rates of around 5% or less) and paying it down over the full 15 years probably isn't the best move, though it certainly would give you some more pocket change in the short run. Your monthly payments would drop to $1,028, saving you more than $700 a month. But you'd pay $55,045 in interest over the next 15 years, far more than you'd have to pay if you simply kept your old loan.

If you refinance into a 10-year loan, the math looks a bit better, but you still don't come out ahead on interest. Total interest over the 10-year span would be $35,500. With your closing costs added in, it's not a good deal.

Paying down your loan early, however, can dramatically change the numbers. Say you refinance into a 15-year loan at 5% interest and continue to make your old monthly payments of $1,740 a month until the loan is finished off. Under this scenario, you'd be done with your loan in seven and a half years, with a total interest bill of $26,000. Even after paying closing costs, you'd save several thousand dollars on interest and be free of debt before you would have been had you kept the old loan. The numbers are more or less the same if you refinance into a 10-year loan and continue to pay $1,740 a month.

Of course, there are other ways to configure the payment schedule; for example, you could choose to pocket a little bit of the monthly savings if you want some more spending money and still finish ahead. For example, you could pay $100 less each month than with your old loan and wind up paying just $28,000 in interest over the life of the new one -- still a healthy savings; plus, you'll be free of debt in about eight years, the same as before. The critical point is to avoid extending the term of your mortgage. For example, if you only have eight years left on your home loan, you don't want to make payments for more than eight years on your new loan. And you most certainly wouldn't want to refinance from a 15-year mortgage into a 30-year loan. Pay as much as you can each month -- it only saves you interest in the long run.

-- Mr. Barta is a staff reporter for The Wall Street Journal. His "House Talk" column appears every Friday exclusively on

Reprint permission available from the Wall Street Journal.

Assignment:

Analyze the couple’s refinancing dilemma, consider the columnist’s response, and recommend a refinancing strategy for the couple. Do you agree with the Yahoo!-Zillow Real Estate Network comment: “make sure you do the math and understand how the new loan will affect you.” What math should be performed? Is there an overall best measure of beneficial effect that should be calculated? Do you agree with the columnist’s recommendations? Do you agree with the “rules of thumb advice?”

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[i] “What You Need to Know about Home Refinancing,” Yahoo-Zillow Real Estate Network, June 29, 2012.

[ii] Glink, Ilyce, “Should You Refinance? The Rule of Thumb has Changed,” Moneywatch, April 27, 2009. 

[iii] Barta, Patrick, “When is Refinancing in Your Best Interest?” Wall Street Journal, Real Estate, Digital Network, July 11, 2003.

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