finance homework due tonight
Mortgage Refinance Project BACKGROUND This project will give you some insight into how to analyze the refinancing of a mortgage. This will certainly be valuable knowledge for you to use in your personal life in the future. One thing you should know is that mortgage refinance consultants at various banks are not all trained equally. While exploring refinancing my own mortgage recently, I found that only 1 consultant was able to properly tell me the breakeven time on my refinance (more to come on that). I found some pretty creative ways to look at this so-called breakeven time. I also had a consultant flat-out tell me that I should not refinance with a certain option, even though that was not the case once I ran the numbers. COST TO REFINANCE Explore the webpage https://www.consumerfinance.gov/owning-a-home/loan-estimate/ and look at the 3-page example Loan Estimate. On page 2 you will find a breakdown of the various items that will be added to your current loan balance as Loan Costs which is essentially the cost to refinance. Most of the items in the right column you will be paying anyway (taxes and insurance). So, these should really be ignored. However, the items in the left column are specific to the refinance, and these are the costs to refinance your loan. One of those costs to refinance is Points. Points are charged to get a lower interest rate. If you are charged 1 point, then you will be charged 1% of the loan amount. Since this will increase your loan amount, the amount charged in points will go up as well (assuming you role those costs into the loan). For example, 1 point on 100,000 is 1000, but since you will put that 1000 into the loan, the loan amount is now 101,000 and the points charged is now 1010, which makes the loan actually 101,010, which now makes the points charged 1010.10, etc. etc. etc. An easy way to get to the actual impact of the points is to divide (by 1 minus points as %) instead of multiply. Instead of 100,000 x 1%, try 100,000/(1- 1%)=100,000/.99=101,010.10. Now if you are charged 1% on this loan amount, you will be charged 1010.10, and will be left with the full 100,000 which you needed to borrow. Don’t forget to add the loan costs into your loan amount before tacking on the points charged. The formula essentially becomes (Current Balance + Fees) / (1 - Points as a %). BREAK-EVEN TIME So, to keep it simple, if the bank is going to require you to pay fees to refinance, then they must drop your interest rate enough so that you save enough interest soon enough to offset the cost to refinance. There are 4 methods that we will explore that I ran across in my exploration. 2 Methods could actually be called Break-Even Time: Basically, your loan balance will be increased by the cost to refinance, but your interest rate is lower, so that your loan balance will drop quicker. At some point in the future, the balance on your loan will be identical whether or not you refinance. Arguably, this is the Break Even Time of the refinance. Assume that you roll the refinance costs into the mortgage so that there is no cost today for which to account. Also, when you refinance, it is likely that your required payment will drop. You have to decide whether to start making the new payment or keep making the same payment you were already making on your current loan. https://www.consumerfinance.gov/owning-a-home/loan-estimate/ Alternative A: I’m assuming that some banks offer this as a Break-Even time because it is easy to calculate. However, it has its issues. First, calculate your new payment with the new loan and see how much you save per month below your current payment. Then divide the total cost to refinance by the amount saved per month. For example, if you had $7000 in refinancing costs and your monthly payment went from $1070 to $1000. Your Break-Even Time would be quoted as 7000/70 = 100 months. This, supposedly, would give you how long it takes to recover your cost to refinance. However, this is not a Break-Even Time. Still, many banks and financial help websites use this method to inform consumers. Perhaps a better name for this would be the Payback time, and that assumes you pay the closing costs upfront rather than rolling them into the new loan. Alternative B: This method that I discovered was just deceptive (in my opinion). It misleads consumers by quoting a much shorter Break-Even time. This method was to calculate at what time in the future the new loan balance would be back to where the current loan balance is now. This was also referred to as the Break-Even Time (definitely incorrect). Calling this Break-Even Time completely ignores the fact that you have to make payments every period from now until then. PROJECT Your original loan balance was $270,000 and, at a rate of 4.125% annually, was to be paid off with equal monthly payments of $1308.56 over 30 years. You have been paying the loan as required over the last 8 years, and therefore you currently owe $226,817.86 and have 22 years remaining on your mortgage (Calculate the Future Value of the original loan over 8 years to verify the current loan balance). Interest Rates have recently dropped and you are thinking about refinancing the mortgage. A mortgage refinance agent has quoted you the following 20-year term refinance options. Assume that $5000 of closing costs will be added to the loan balance in addition to the points charged regardless of which option is chosen. The points are charged on the entire new loan balance including the points. • Option 1: 3.000% annual rate with no points • Option 2: 2.875% annual rate with 0.5 points • Option 3: 2.750% annual rate with 1 point • Option 4: 2.625% annual rate with 1.5 points • Option 5: 2.500% annual rate with 2 points • Option 6: 2.375% annual rate with 2.5 points • Option 7: 2.250% annual rate with 3 points Use Excel to analyze the options by calculating the missing amounts in the Excel Template. 1. How much interest will you save over the life of the loan under each option? 2. Use Excel’s “Goal Seek” to calculate the actual Break-Even Time of each of the options listed using the current loan payment. 3. Use Excel’s “Goal Seek” to calculate the actual Break-Even Time of each of the options listed using the new loan payment. 4. Calculate the times described by Alternatives A and B for each option above. 5. Write your analysis of your findings in the Excel spreadsheet. Use the following questions as a prompt. Should you refinance? If so, which option is best? Which is the best Break-Even Time on which to base your decision? What are the holes in the other methods? Does it matter if you plan to sell your home in 3 years, in 5 years, never? Does the risk/unknown of when you may sell or refinance come into play? Does the total amount saved matter?