Mortgage Refinancing Decision Falling interest rates create opportunities for refinancing because the option is now “in the money”. “Out of the money” mortgage may be refinanced for other reasons Refinancing even in the case of falling rates may or may not be beneficial To make a sound refinancing decision we must consider the benefit as well as the cost of refinancing

Variables Influencing Refinancing Decision MortgagePrepayment penalty –existing loan existing loan –new loan new loan Interest rate Financing costs –new loan new loan –existing existing Mortgage Maturity Holding period –remaining term –new loan term Discount rate

An illustration: The Original loan Assumptions Existing Mortgage ·Original loan amount$50,000 ·Interest Rate12 percent ·Term30 years ·Age of mortgage5 years ·Prepayment Penalty5 percent. Monthly payment

Parameters of new loan NEW MORTGAGE ·Loan Amount=Outstanding balance on old loan ·Interest rate= 10½ percent ·Term= 25 years ·Refinancing costs=3% ·Holding period=Hold mortgage until maturity ·Borrower's =13 percent opportunity rate

Refinancing Decision Determine Outstanding Balance on Old Loan First determine monthly payment $50,000=PV 12/12 =i 30 x 12=n PMT=$514.30

Refinancing Decision Outstanding balance at the end of 5th year $514.30=PMT 12/12=i 25 x 12=n PV=$48,831 Therefore the outstanding balance on the old loan = $48,831

Refinancing Decision Determine Monthly Payment on New Loan Payment: $48,831=PV 10.5/12=i 25 x 12=n PMT=$461.05

Refinancing Decision Determine Cost of Refinancing Prepayment Penalty on existing loan =.05 x $48,831 =$2,442 Plus financing cost on new loan =.03 x $48,831 =$1,465 TOTAL : $3,907

Refinancing Decision Determine Benefit of Refinancing Monthly payments on existing loan=$ Less Monthly payments on new loan= TOTAL$ 53.25

Refinancing Decisions Determine Present Value of Savings Present value of savings $53.25=PMT 13 /12 =i 25 x 12=n PV=$4,721 Net present value =$4,721 - $3907 = $814 What is the yield on this mortgage refinancing investment?

Refinancing Summary: Find present value of savings Subtract cost from PV of savings If positive NPV refinance If negative NPV do not refinance Note: you may refinance but hold the new mortgage for a period less than outstanding term of old loan. Think of the consequence of this in computing NPV

Wraparound Mortgage Junior mortgage that wraparounds or includes an existing first mortgage Permits a second lender to extend additional debt to the borrower by lending an amount above the balance outstanding on the existing first mortgage The additional amount is extended without the borrower paying off the balance outstanding on the first mortgage

Some Important Features The face value of the loan = balance on existing first mortgage + amount actually extended by the wrap lender The debt service is based on face value of the wrap loan. The interest rate is typically below market but above that of the existing first loan Borrower makes one payment to the wrap lender The wrap lender keeps his/her share of payment and passes on the remaining portion to the first lender

An Example An $800,000 mortgage has 25-year maturity and calls for level monthly payments based on an annual interest rate of 7%. At the end of the 15th year with market interest rate now at 9% the borrower requests an additional amount of $200,000, but the first lender is unwilling or unable to advance the additional funds. A new lender agrees to wraparound the outstanding balance on the existing first loan the $200,000 requested by the borrower, at an annual interest rate of 8% for 10 years, with monthly payments. Problem: Determine the expected yield to the wraparound lender.

Steps A. Calculate the debt service on the original loan monthly debt service = * 800,000 = $ B. Find the balance outstanding on first mortgage PV. of 7% for 10 years = * = $486,

Steps C. Find the debt service on wraparound loan face value = 486, ,000 = $686, monthly debt service = 686, * = $

Steps D. Find the net debt service to the wrap lender $ $ = $ , this is the actual cash flow that goes to wrap lender E. Find the IRR to the wrap lender PV = -200,000 CF = $ n = 10*12 = 120 Monthly IRR = Annual IRR = 10.34% Why is the IRR > than the contract rate?