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Refinance Rule of Thumb Is Faulty

September 13, 1998|JACK M. GUTTENTAG | SPECIAL TO THE TIMES; Jack M. Guttentag is a syndicated columnist and a professor of finance emeritus at the Wharton School of Business of the University of Pennsylvania

QUESTION: Since it costs money out of my pocket to refinance, how do I know whether I will end up saving money?

ANSWER: To save money, you must stay in your house longer than the "break-even period"--the period over which the savings will cover all the costs.

The larger the spread between the new interest rate and the rate on your existing loan, the shorter the break-even period. The more it costs to obtain the new loan, the longer the break-even period.

But be careful: The break-even period is not the cost of the new loan divided by the reduction in the monthly mortgage payment.

This widely used rule of thumb is a misapplication of the principle that when explaining something to the consumer, one should keep it simple. Simple is good, except when it's wrong.

One important thing the rule of thumb omits is the difference in how rapidly you pay off the new loan as opposed to the old one. Here's an example:

Let's say that in 1989 you took out an 11% 30-year fixed-rate loan, which now has a $100,000 balance and 21 years to run. You refinance into a 7% 15-year loan at a cost of $3,750.

* Monthly payment on the old loan: $1,019.

* Monthly payment on the new loan: $899.

* Reduction in monthly payment: $120.

* $3,750 divided by $120: 31 months.

The rule of thumb says that you break even in 31 months.

However, because of the shorter term and lower rate on the new loan, in 31 months you would owe $7,041 less than you would have owed on the old loan.

So the rule of thumb in this case greatly overstates the break-even period. Taking account of differences in the loan balance, you would actually be ahead of the game in 12 months, as shown below:

* Savings in monthly payment: $120 for 12 months, or $1,440.

* Plus lower loan balance in month 12: $2,620.

* Equals total savings from refinance: $4,060

* Less refinance cost of $3,750.

* Equals net gain: $310.

Next, consider the case where the 11% loan you took out in 1989 was for 15 years and, even though it has only six years left to run, you plan to refinance into a 30-year loan.

With the remaining term shorter on the old loan and longer on the new one, the difference in monthly payment rises to $1,238.

Using the rule of thumb, the $3,750 cost would be recovered in only three months. But this fails to consider the slower loan repayment on the new loan.

Taking account of the slower repayment, you don't actually come out ahead until 14 months later.

The upshot is that the rule of thumb (dividing the upfront cost by the reduction in mortgage payment) provides a tolerable approximation to the true break-even period only if the term on your new loan is close to the unexpired term on your old loan.

In other circumstances, it can lead you seriously astray.

The rule of thumb also ignores the fact that if you had not refinanced, you could have earned interest on the money you pay upfront to refinance, and if you do refinance and the payment is reduced, you can earn interest on the savings.


Distributed by Inman News Features.

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