Submitted by: Submitted by Alexdoan
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Words: 1000
Pages: 4
Category: Business and Industry
Date Submitted: 06/01/2016 01:42 PM
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...