How Refinancing a Mortgage Affects Your Net Worth

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How Refinancing a Mortgage Affects Your Net Worth

Most of the time, refinancing sounds like a terrific solution to lower your monthly mortgage payments and provide you more cash for other expenses. When assessing the benefits and drawbacks of a refinancing, don’t forget to take your net worth into account.

Why? Monthly payments are just one aspect of a mortgage. It is a kind of financial financing used to purchase an asset. And according to that accounting professorese lingo, having a mortgage reduces your net worth.

Here is how the logic works. A mortgage is a liability on a family’s balance sheet. As a result, to calculate the household’s net worth, it is deducted from its assets. Refinancing a mortgage to decrease monthly payments is a trap that too many customers fall into without taking into account how it may effect their overall net worth. Does house refinancing ever pay off? Or is it merely a band-aid for a greater issue?

Key Takeaways

  • When a homeowner’s cumulative savings exceed the cost of a refinancing, the month at which this occurs is often determined using a simple payback period technique.
  • Calculating the cost of refinancing by taking into account the effect on your household’s net worth is a more prudent financial move.
  • Homeowners must examine the remaining amortization schedules of their current and new mortgages to determine whether a refinancing option is financially feasible.

The Payback Period Method

The most common approach to figuring out the economics of refinancing a mortgage includes computing a straightforward payback period. This equation is constructed by totaling the monthly payment savings that may be generated by refinancing into a new mortgage at a lower interest rate and identifying the month in which those cumulative monthly payment savings exceed the refinancing fees.

Consider that you have a $200,000, 30-year mortgage loan. You received a fixed interest rate of 6.5% when you took it out, and your first-of-the-month payment is $1,264. Your monthly payment may drop to $1,136 if fixed interest rates are now at a rate of 5.5%. This would result in a savings of $128 per month, or $1,536 per year. According to the conventional wisdom, you should think about refinancing if you can lower your current interest rate by 0.75% to 1% or more.

  Mortgage Calculator

A mortgage calculator is a useful tool for comparing these expenses.

You must next request that your new lender estimate the entire closing expenses associated with the potential refinancing. If they total $2,300, for instance, your repayment term in the house would be 1.5 years ($2,300 divided by $1,524). Refinancing makes sense, at least using the standard payback term technique, if you intend to remain in the house for two years or more.

What the Payback Period Method Misses

The household’s financial sheet and the calculation for total net worth are disregarded by this approach. There are two main items that are missing.

Cost of Refinancing

The simple payback time technique disregards the difference between the principal balance of the old and new mortgages. But refinancing costs money. Refinancing fees must be paid out of pocket or, in most situations, added to the principal amount of the new mortgage.

The liability side of the family balance sheet grows when a mortgage balance is increased via a refinance transaction, and, all other things being equal, the household net worth instantly declines by an amount equal to the refinancing fee.

Total Mortgage Interest Paid

It doesn’t always follow that you will pay less interest overall on your refinanced mortgage just because you are obtaining a lower interest rate. For instance, if you refinance a 30-year mortgage into a new 30-year mortgage with 25 years remaining to pay it off, you may wind up paying higher interest overall throughout the course of the new mortgage. How much lower the new interest rate is will determine everything.

The Household Net Worth Method

Comparing the remaining amortization schedule of the current mortgage to the amortization schedule of the new mortgage is a more financially sound technique to calculate the economics of refinancing that takes the real expenses into the family net worth calculation.

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The refinancing fees will be deducted from the principal amount and included in the new mortgage’s amortization schedule. For a fair comparison, the principal balance of the current mortgage should be deducted by the same dollar amount if the expenses of refinancing would be paid out of pocket. This is based on the idea that the money you would spend on charges if the refinancing transaction didn’t go through may be utilized to lower the principle amount of the current loan instead.

Subtract the principle amount of the new mortgage from the monthly payment savings between the two loans. This is done because, theoretically, you might utilize the monthly savings produced by refinancing to lower the new mortgage’s principal amount. A really economical refinancing payback time, one based on family net worth, is obtained when the adjusted principal amount of the new mortgage is lower than the principle balance of the previous mortgage.

By the way, the majority of websites devoted to mortgages have amortization calculators. The findings may be copied and pasted into a spreadsheet software, where you can then execute the extra computation of deducting the monthly payment variations from the principle amount of the new mortgage.

An Example of the Household Net Worth Method

Using the calculations mentioned above, the results of a refinance analysis of an existing mortgage with a fixed interest rate of 7%, 25 years until repayment, a principal balance of $200,000, and refinancing costs of $3,000 (which will be added to the principal balance of the new mortgage) into a new 30-year mortgage are as follows:

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The cumulative monthly payment savings exceed the $3,000 refinancing expenses starting in month 19 if a straightforward payback period analysis is done to estimate the economics of refinancing in the case above. In other words, the basic payback period technique informs us that refinancing makes sense if the homeowner anticipates holding the new mortgage for 19 or more months.

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The choice to refinance would only become financially viable if the net worth strategy were employed, which would not happen until month 29, when the principle amount of the new mortgage less the cumulative monthly payment savings would be less than the main balance of the old mortgage. According to the net worth technique, it takes 10 more months than the standard payback term strategy before refinancing is cost-effective.

The damage to your net worth may be considerably worse if you refinance after your house has decreased in value and must pay private mortgage insurance.

Special Considerations

Remember that many properties are evaluated for substantially less than they were previously worth during times when property values decrease. Due to this, you may not have enough equity in your property to cover the 20% down payment on the new mortgage, necessitating a higher cash deposit than you had anticipated.

Private mortgage insurance (PMI), which would eventually raise your monthly payment, can also be necessary. Even with the decrease in interest rates in certain situations, your actual savings may not be significant.

The Bottom Line

You may precisely calculate the repayment time with which you must deal by evaluating the true economics of refinancing your mortgage. Even though number crunching requires some effort, anybody can do it.

Calculating the true economics of refinancing your mortgage may very well save you from depleting your net worth by thousands of dollars, especially if you have moving plans in the near future. You will also know much more precisely when you will start to reap the rewards of refinancing if it does seem that doing so would be beneficial.

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