Don't refi for the wrong reasons
Breakeven period should take no more than 4-5 years
By Jack Guttentag, Monday, December 21, 2009.In a recent article on lifestyle mistakes by mortgage borrowers, I gave an example of such a mistake that touched a nerve on the part of some readers. I said in the article that many borrowers would find irresistible the deal I labeled a mistake, and I was right. Some readers did find the deal I described as irresistible, and were completely convinced that I was wrong in saying that it was a loser.
The borrower in my example had a 6 percent loan with a $200,000 balance and 10 years to go. She is offered a 5.75 percent refinance for 30 years that will reduce her monthly payment from $2,220 to $1,267. Although the borrower was not required to put up any cash, upfront charges amounting to $17,000 had to be financed -- that is, included in the loan amount.
The readers who said that this deal would have been irresistible to them focused on payment savings and ignored or understated changes in the borrower's loan balance. They are payment-myopic, which is a pervasive malady among households who never seem to be able to get out of debt.
The most common approach of my payment-myopic readers was to divide the $17,000 of upfront charges by the $953 of monthly payment savings to derive a "breakeven period" of 18 months. Stay longer than 18 months, they told me, and it is all gravy.
Not so. There is a valid way to calculate a breakeven period, as I will show below, but that isn't it. The borrower would not have broken even after 18 months because at that point she would owe $35,658 more if she refinanced than if she didn't. That is a far cry from breakeven.
My preferred way to analyze this type of problem is to estimate the borrower's wealth if she refinances, compared to what it would be if she didn't refinance, after an elapsed period equal to the number of years the borrower expects to be in the house. I will assume that period is five years. ...CONTINUED
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Submitted by Robert T. Boyer, Ph.D. on December 21, 2009 - 10:40am.
Jack,
Thank you. Too few people consider the long term effects. There were a few items that jumped out as worth extra consideration.
$17,000 - seems a completely outrageous amount to be paying for a refinance. That is 8 1/2 percent of the loan amount. In and of itself that should be a huge red-flag alerting you to the bull.
The 4-5 years is an excellent rule of thumb. However, it is not always so cut and dried when you consider the following:
a) How long do the buyers truly intend to stay? My father has been in his house 44-years. Most people are more mobile. The typical owner stays in a home 7-9 years.
b) Were the borrowers moving from a variable rate to a fixed rate? The inflation risk is substantial right now (although it would not have mattered sufficiently in the example as laid out).
c) How tight are the current family finances? People/companies do not go bankrupt because they don't have assets but because they don't have sufficient cashflow. With unemployment and under-employment, this can be a serious factor today.
But, as they say, those are edge-cases that apply to few people and as to the meat of the example, people really need to hear and understand your message.
- Former resident at Speakman 117 in the Quad!
Robert T. Boyer, Ph.D.
Co-Founder - http://www.FinestExpert.com
VP http://www.AmericasFinestRealEstate.com