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					      Principles of Real Estate
                     Refinancing

 Identify the amount and timing of the (before tax) costs and
  benefits

 Decision rules: (Before Tax) IRR or NPV

 Examples:

    1. Refinance just the existing mortgage balance with a new
       loan that has the same remaining term as the existing loan

    2. Include some refinancing costs with the new loan

    3. Refinance with shorter maturity
 Principles of Real Estate
                 Refinancing

                Refinancing Costs

 Loan origination fees

 Discount Points

 Other "closing" costs ( we'll discuss these in
  detail later in the semester)

    o title insurance
    o appraisal
    o document preparation fees
    o recording fees
    o legal expenses
     Principles of Real Estate
                     Refinancing

                   Refinancing Benefits

At least one of:

   Lower monthly payment

   Lower future mortgage balance

   Shorter loan term
                 Principles of Real Estate
                                Refinancing

                             The Refinancing Decision

Some notation:

REFI        =    out of pocket refinancing costs
OLD_PMT     =    monthly payment on existing mortgage
NEW_PMT     =    monthly payment on new mortgage
OLD_MB      =    mortgage balance on existing loan
NEW_MB      =    mortgage balance on new loan
s           =    month loan will be repaid
y           =    required (before tax) yield on cash flows
                                           s
                                                   1                                  1
BTNPV = - REFI + (OLD_PMT - NEW_PMT)                     t
                                                                OLD_MB- NEW_MB            s
                                           t=1    y                                  y
                                                 1+                                1 
                                                  12                               12 
          Principles of Real Estate
                        Refinancing
                           Example 1a

Five years ago, you financed the acquisition of a $150,000 house
with a $120,000, 8% annual interest rate, 30 year, monthly
payment mortgage. The loan does not have a prepayment penalty.

Current market rates for 25 year, monthly payment mortgages have
dropped to 6.5%. Lenders typically charge a $1,000 loan
origination fee and $1,500 in discount points for these loans.

Additional closing costs amount to $2,500. Should you refinance
the existing mortgage if you discount future expected before tax
cash flows at 7%? Assume you will pay all refinancing costs (e.g.
loan fees, discount points, and closing costs) when you refinance.
    Principles of Real Estate
                    Refinancing

Existing Mortgage

Loan Amount (5 years ago):        $ 120,000.00

Annual Interest Rate:                   8.00%

Loan Term:                            30 years

Monthly Payment:                     $ 880.52

Current Mortgage Balance:         $ 114,084.15
    Principles of Real Estate
                    Refinancing

New Mortgage

Loan Amount (today):                         $ 114,084.15

Annual Interest Rate:                               6.50%

Loan Term:                                        25 years

Monthly Payment:                                  $ 770.30

Monthly savings: $ 880.52 - $ 770.30     =        $ 110.22

So if you refinance, you will save $110.22/month for the next
300 months (25 years). Note: the maturity for the new loan is
the same as the remaining term for the existing loan.
    Principles of Real Estate
                    Refinancing

                The Cost of Refinancing


Loan Origination Fee                      $ 1,000.00

Discount Points                           $ 1,500.00

Closing Costs                             $2,500.00

Total Cost                                $5,000.00
         Principles of Real Estate
                      Refinancing

                       Should You Refinance?

Is saving $110.22/month for the next 300 months worth more than the
$5,000.00 cost today?

                                    300
                                              1
BTNPV = - $5,000.00 + $110.22                        t
                                     t=1    0.07 
                                           1+    
                                              12 


        = - $5,000.00 + $ 15,594.69 = + $ 10,594.69

BTIRR = 26.41%
           Principles of Real Estate
                          Refinancing
                              Example 1b

It is unlikely that you will continue to make monthly payments on the
mortgage for the next 25 years. Should you refinance the existing
mortgage if you expect to prepay (either) loan at the end of four years?

OLD_MB48 =                                  $ 107,324.48

NEW_MB48 =                                  $ 105,757.72


Difference in Mortgage Balances:               $ 1,566.76

Note: in addition to the lower monthly payment, the 6.5% rate loan has
a lower mortgage balance in four years. This is because lower interest
rate loans amortize more rapidly than higher interest rate loans.
    Principles of Real Estate
                 Refinancing

                       Example 1b

                 Should You Refinance?

                           48
                                    1                1,566.76
BTNPV = -5,000.00 + 110.22                 t
                                                               48
                           t=1    0.07             0.07 
                                 1+               1     
                                    12                12 

      = - $5,000.00 + $ 4,602.81 + $ 1,185.10

      = + $ 787.90

BTIRR = 13.38%
          Principles of Real Estate
                         Refinancing
                    Can you do better than this?

                            Example 2a

Lenders will usually allow borrowers to include most refinancing
costs with the new loan amount. Recompute the BTNPV and
BTIRR assuming the lender allows the borrower to include the
discount points and closing costs in the new loan amount, but
requires that the borrower pay the $1,000 loan fee at origination.

New loan amount     = Old loan balance + points + closing costs

                    = $ 114,084.15 + $ 1,500 + $ 2,500

                    = $ 118,084.15
    Principles of Real Estate
                    Refinancing

                        Example 2a

New Mortgage

Loan Amount (today):                       $ 118,084.15

Annual Interest Rate:                            6.50%

Loan Term:                                     25 years

Monthly Payment:                              $ 797.31

Monthly savings:    $880.52 - $ 797.31 =        $ 83.21
             Principles of Real Estate
                           Refinancing
                             Example 2a
                        Should You Refinance?

Is saving $83.21/month for the next 300 months worth more than the
$1,000.00 cost today?

                                300
                                         1
BTNPV = - $1, 000.00 + $83.21                   t
                                t=1    0.07 
                                      1+    
                                         12 

        = - $1,000.00 + $ 11,773.13 = + $ 10,773.13

BTIRR = 99.85%

The BTNPV is $178.44 higher while the BTIRR is MUCH higher. Why?
           Principles of Real Estate
                          Refinancing
                               Example 2b

Should you refinance the existing mortgage if you expect to prepay
(either) loan at the end of four years?

OLD_MB48 =                                   $ 107,324.48

NEW_MB48 =                                   $ 109,466.03

Difference in Mortgage Balances:              - $ 2,141.55

Note: the mortgage balance on the new loan IS LARGER than the
mortgage balance on the existing loan. Why?

The difference would be an additional cost, not a benefit, in four years.
      Principles of Real Estate
                     Refinancing

                       Example 2b.

                 Should You Refinance?

                         48
                                  1                2,141.55
BTNPV = -1,000.00 + 83.21                t
                                                             48
                         t=1    0.07             0.07 
                               1+               1     
                                  12                12 

      = - $1,000.00 + $ 3,474.87 - $ 1,619.87

      = + $ 855.00


BTIRR = 91.03%
        Principles of Real Estate
                       Refinancing


                            Example 3

Annual interest rates for 15-year mortgages are 5.75% (75 basis
points lower than the market rate on 30-year mortgages). Does it
make sense to take advantage of the lower interest rate? Assume the
lender will allow you to include the $1,500 in discount points and
the $2,500 closing costs in the new loan amount. Should you
refinance if you expect to:

   3a. hold the loan to maturity; or

   3b. prepay the loan in four years.
        Principles of Real Estate
                        Refinancing
                            Example 3a
New Mortgage

Loan Amount (today):                              $ 118,084.15

Annual Interest Rate:                                   5.75%

Loan Term:                                            15 years

Monthly Payment:                                      $ 980.58

Monthly 'savings'
 for the next 180 months:   $880.52 - 980.58 =      - $ 100.06
 for months 181-300:                                + $ 880.52

Now the monthly payment on the new loan is $100.06 HIGHER
THAN the monthly payment on the old loan, for next 15 years. After
that, the borrower saves the entire payment on the old loan.
           Principles of Real Estate
                          Refinancing
                              Example 3a

                         Should You Refinance?


                              180                          300
                                       1                               1
BTNPV = - $1,000.00  $100.06                 t
                                                    $880.52                  t
                              t=1    0.07                t181    0.07 
                                    1+                           1     
                                     12                              12 

       = + $ 14,486.68


BTIRR = 12.65%
            Principles of Real Estate
                          Refinancing
                              Example 3b

Should you refinance the existing mortgage if you expect to prepay
(either) loan at the end of four years?

OLD_MB48 =                                 $ 107,324.48

NEW_MB48 =                                  $ 95,759.50

Difference in Mortgage Balances:           + $ 11,564.98

Note: the benefit comes when you repay the loan balance in four years.
       Principles of Real Estate
                    Refinancing
                       Example 3b.

                 Should You Refinance?

                          48
                                   1               11,564.98
BTNPV = -1,000.00  100.06                t
                                                              48
                          t=1    0.07             0.07 
                                1+               1     
                                   12                12 

      = - $1,000.00 - $ 4,178.53 + $ 8,747.74

      = + $ 3,569.21


BTIRR = 27.53%
       Principles of Real Estate
                     Refinancing
                        BTNPV Summary
                           (At 7%)

                        6.50% rate          5.75% rate
                     Pay all   Pay just       Pay just
                    REFI costs loan fee       loan fee
Loan

Held to maturity:   +$10,595 +$10,773        +$14,487


Prepaid in 4 yrs:     +$788       +$855        +$3,569

The 15-year loan dominates the 30-loan, regardless of holding
period; provided you can make the higher monthly payments.

				
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