Loan Refinance

Loan Refinancing

Refinancing is an investment decision, comparing benefits to cost.

Net Benefit = Benefit of Payment Reductions – Cost of

Refinancing

The fundamental relationships to know in any loan refinancing decision include at least three

ingredients:

(1) terms on the present outstanding loan,

(2) new loan terms being considered, and

(3) any fees associated with paying off the existing loan or acquiring the new loan (e.g.,

prepayment penalties on the existing loan or origination and closing fees on the new loan).

Example:

Assume a borrower made a mortgage loan 5 years ago for 80,000 at 15% interest for 30 years

(monthly payment). After 5 years, interest rates fall, and a new mortgage loan is available at 14%

for 25 years. The loan balance on the existing loan is 78,976.50. Suppose that the prepayment

penalty of 2% must be paid on the existing loan, and the lender who is making the new loan

available also requires an origination fee of 2,500 plus 25 for incidental closing costs if the new

loan is made. Should the borrower refinance?

Cost to refinance:

Prepayment penalty: (2% * 78,976.50)

Origination fees and discount points, new loan

Recording, etc., new loan

Benefits from refinancing:

Monthly payments, existing loan, 80,000, 15%, 30 years

Less: payments, new loan, 78,976.50, 14%, 25 years

Monthly savings

1,580

2,500

25

4,105

1,011.56

950.69

60.87

I (n, PV, PMT, FV) = I (300, -4,105, 60.87, 0) = 17.57%

The yield on our 4,105 investment, with savings of 60.87/month over 25 years, is equivalent to

earning an annual rate of 17.57%. If another alternative equal in risk, which provides a 17.57%

annual return, cannot be found, the refinancing should be undertaken. This return appears to be

attractive because it is higher than the market rate of 14% that must be paid on the new loan.

Thus, refinancing is probably desirable.

Effective Cost of Refinancing

The refinancing problem can also be analyzed by using an extension of the...