How to Know if Refinancing Will Make You Money
You need to know the net present value (NPV) of refinancing vs. keeping your current mortgage. This blog will explain why using NPV is very different from what other calculators out there tell you.
Other Refinance Calculators Have Major Flaws
Most online calculators don’t tell you in today’s dollars the benefit or cost associated with refinancing. They instead tell you how long it will take you to recover your transaction fees, or the nominal cost difference of your current mortgage vs your existing mortgage.
Both of these pieces of information have limited use. What you really need to be able to do is compare refinance options that have different rates, maturities, and fees. It is then important to factor in how long you plan to live in the home.
You also can’t simply compare a new 30-year mortgage to an existing 30-year mortgage that may have only 23 years of life remaining. Somehow you need to account for differences in initial mortgage term, remaining term, rate, and broker fees. The only way to do that on the same basis is to compare the NPV of future cash flows associated with each option.
What is NPV?
The NPV concept basically means that a dollar today is worth more than a dollar tomorrow. Why is that? You can invest the dollar received today and earn interest on it. If you can make 3% interest on your money, you should be indifferent to receiving $100 today and $103 a year from now. If you fail to treat $103 a year from now differently from $103 today, your analysis is seriously flawed.
Example: NPV vs. Nominal Value
A mortgage broker might say that you can save $200 per month on a refinance that costs you $5,000. If the term is 30 years, you can save $200 x 12 months x 30 years – $5,000 = $67,000.
However, the NPV of those 30 years of cash flows at 3% interest is actually only $47,438-$5,000 = $42,438. A huge difference from $67,000. But that’s not the end of the story. If your original mortgage had only 15 years of life remaining, you will now be extending your payments for an additional 15 years. So you also need to know the cost associated with that extended payment schedule. Not so simple, and most brokers have absolutely no idea how to do that.
Improved Refinance Calculator
The attached calculator will enable you to do all of that, as well as input an estimate of how long you plan to live in the home. If only five years, and it takes you ten years to realize sufficient savings on an NPV basis, then the refi doesn’t make sense. This calculator will tell you the actual NPV of the savings or cost associated with the new mortgage relative to your current mortgage.
