MORTGAGE CALCULATIONS AND DECISIONS

Chapter 15
Real Estate Principles: A Value Approach by Ling and Archer, 5th Ed.
OUTLINE

• Fixed-payment (LPM) calculations

without prepayment
• Fixed-payment (LPM) calculations
with prepayment
• ARM calculations
• Refinancing
LEVEL PAYMENT MORTGAGE (LPM)
• A level payment mortgage (aka fixed-rate mortgage) is a type of home
loan where the borrower pays a fixed amount of principal and interest
on a regular basis over the life of the loan. At maturity, the loan balance is
zero.
• The term "level payment" refers to the fact that the payment amount
remains constant over time, but the composition of the payment
changes as the loan is paid down.
• In the early years of the loan, most of the payment goes towards paying
interest, while in the later years, most of the payment goes towards
paying down the principal.
• Suitable for homeowners who plan to stay in their homes for a long
period of time, as LPMs provide a consistent payment schedule for the
duration of the loan.
 Annual interest rate 7%
=PMT($C$1/$C$3,$C$2*$C$3,$C$4)

SIMPLE AMORTIZATION
Loan terms (in yrs.) 2
Payment/yr. 12
Loan amount 50,000
=IPMT($C$1/$C$3, A8, $C$2*$C$3, $C$4)
=PPMT($C$1/$C$3, A8, $C$2*$C$3, $C$4)
Period Payment Interest Principal Balance
1 ($2,238.63) ($291.67) ($1,946.96) $48,053.04 =C4+D8
2 ($2,238.63) ($280.31) ($1,958.32) $46,094.72 =E8+D9
3 ($2,238.63) ($268.89) ($1,969.74) $44,124.98 =E9+D10
4 ($2,238.63) ($257.40) ($1,981.23) $42,143.74 =E10+D11
5 ($2,238.63) ($245.84) ($1,992.79) $40,150.95
6 ($2,238.63) ($234.21) ($2,004.42) $38,146.54
7 ($2,238.63) ($222.52) ($2,016.11) $36,130.43
8 ($2,238.63) ($210.76) ($2,027.87) $34,102.56
SCHEDULE

9 ($2,238.63) ($198.93) ($2,039.70) $32,062.86

10 ($2,238.63) ($187.03) ($2,051.60) $30,011.27
11 ($2,238.63) ($175.07) ($2,063.56) $27,947.70
12 ($2,238.63) ($163.03) ($2,075.60) $25,872.10
13 ($2,238.63) ($150.92) ($2,087.71) $23,784.40
14 ($2,238.63) ($138.74) ($2,099.89) $21,684.51
15 ($2,238.63) ($126.49) ($2,112.14) $19,572.37
16 ($2,238.63) ($114.17) ($2,124.46) $17,447.92
17 ($2,238.63) ($101.78) ($2,136.85) $15,311.07
18 ($2,238.63) ($89.31) ($2,149.31) $13,161.75
19 ($2,238.63) ($76.78) ($2,161.85) $10,999.90
20 ($2,238.63) ($64.17) ($2,174.46) $8,825.44
21 ($2,238.63) ($51.48) ($2,187.15) $6,638.29
22 ($2,238.63) ($38.72) ($2,199.91) $4,438.38
23 ($2,238.63) ($25.89) ($2,212.74) $2,225.65
24 ($2,238.63) ($12.98) ($2,225.65) $0.00
LPM CALCULATIONS
• The maximum amount a lender will be willing to loan is the PV of
the future payments that it expect to receive.
• A 30-year, fixed-rate, LPM mortgage. The quoted interest rate is
6%. The monthly payment is $1,000. What is the loan amount?
𝑌𝑒𝑎𝑟𝑙𝑦 𝑟𝑎𝑡𝑒 (𝑅) 6%
• 𝑀𝑎𝑡𝑢𝑟𝑖𝑡𝑦 𝑖𝑛 𝑚𝑜𝑛𝑡ℎ𝑠 𝑛 = 360, 𝑀𝑜𝑛𝑡ℎ𝑙𝑦 𝑟𝑎𝑡𝑒 𝑟 =
12
=
12
=
0.5%, 𝑀𝑜𝑛𝑡ℎ𝑙𝑦 𝑃𝑎𝑦𝑚𝑒𝑛𝑡 𝑃𝑀𝑇 = 1000
1− 1+𝑟 −𝑛
𝑃𝑉 = 𝑃𝑀𝑇 ×
𝑟
1 − 1.005 −360
= 1,000 × = 1,000 × 166.7916144 ≅ 𝟏𝟔𝟔, 𝟕𝟗𝟏. 𝟔𝟏
0.005
MONTHLY LOAN PAYMENTS

• A 15 yr. fixed-rate mortgage. The loan amount is $300,000.

The quoted interest rate is 5.5%. What is the monthly payment?
𝑅 5.5%
• 𝑛 = 15 × 12 = 180, 𝑟 =
12
=
12
= 0.4583%, 𝑃𝑉 = 300,000

𝑟 × 𝑃𝑉
𝑃𝑀𝑇 =
1 − 1 + 𝑟 −180
0.004583 × 300,000 1374.90
= −180
= ≅ 𝟐𝟒𝟓𝟏. 𝟐𝟒
1 − 1.004583 0.5609
QUOTED RATE
• A 20-year mortgage. The monthly payment is $2,000. The
loan amount is $300,000. What is the quoted rate?
𝑌𝑒𝑎𝑟𝑙𝑦 𝑟𝑎𝑡𝑒
• 𝑛 = 20 × 12 = 240, 𝑟 = 12
, 𝑃𝑉
= $300,000, 𝑃𝑀𝑇 = $2000
• We know, 𝑃𝑉 𝑜𝑓 𝐿𝑜𝑎𝑛 = 𝑃𝑉 𝑜𝑓 𝑎𝑙𝑙 𝑓𝑢𝑡𝑢𝑟𝑒 𝑝𝑎𝑦𝑚𝑒𝑛𝑡𝑠
𝑛
−𝑛
𝑃𝑀𝑇 𝑃𝑀𝑇 × 1 − 1 + 𝑟
෍ 𝑛
=
1+𝑟 𝑟
𝑖=1
• If we want to calculate the ‘r’ by hand, we need to follow the
long way- “method of interpolation.”
 𝑛 = 20 × 12 = 240,
QUOTED RATE… 𝑄=
𝑌𝑒𝑎𝑟𝑙𝑦 𝑟𝑎𝑡𝑒
,
12
𝑃𝑉 = $300,000,
𝑃𝑀𝑇 𝑃𝑀𝑇× 1− 1+𝑟 −𝑛 𝑃𝑀𝑇 = $2000
• 𝑛
σ𝑖=1
1+𝑟 𝑛
=
𝑟
2000× 1− 1+𝑟 −240
• 300,000 =
𝑟
, to calculate ‘r’, we need to follow the
interpolation formula: Given
(𝑣𝑎𝑙𝑢𝑒𝑙𝑜𝑤,𝑟 −𝑣𝑎𝑙𝑢𝑒𝑢𝑛𝑘𝑛𝑜𝑤𝑛,𝑟 ) PV
• 𝑟 = 𝑟𝑙𝑜𝑤 +
𝑣𝑎𝑙𝑢𝑒𝑙𝑜𝑤 −𝑣𝑎𝑙𝑢𝑒ℎ𝑖𝑔ℎ
× 𝑟ℎ𝑖𝑔ℎ − 𝑟𝑙𝑜𝑤
• This is the trial-and-error method used in IRR calculation
• In this you need to consider two values for ‘r’: one high and
one low
• Suppose, we assume 𝑄𝑙𝑜𝑤 = 5% 𝑎𝑛𝑑 𝑄ℎ𝑖𝑔ℎ = 7%
 𝑛 = 20 × 12 = 240,
QUOTED RATE… 𝑄=
𝑌𝑒𝑎𝑟𝑙𝑦 𝑟𝑎𝑡𝑒
,
12
𝑃𝑉 = $300,000,
5% 7%
• 𝑟𝑙𝑜𝑤 =
12
= 0.3333% & 𝑟ℎ𝑖𝑔ℎ =
12
= 0.5833 𝑃𝑀𝑇 = $2000

2000 1− 1.0033 −240

• 0.0033
≅ 331,194.5464 [𝑄𝑙𝑜𝑤 = 5%]
2000 1− 1.00583 −240
• 0.00583
≅ 258,044.92 [𝑄ℎ𝑖𝑔ℎ = 7%]
• Using interpolation formula:
(𝑣𝑎𝑙𝑢𝑒𝑙𝑜𝑤,𝑟 −𝑣𝑎𝑙𝑢𝑒𝑢𝑛𝑘𝑛𝑜𝑤𝑛,𝑟 )
• 𝑟 = 𝑟𝑙𝑜𝑤 +
𝑣𝑎𝑙𝑢𝑒𝑙𝑜𝑤 −𝑣𝑎𝑙𝑢𝑒ℎ𝑖𝑔ℎ
× 𝑟ℎ𝑖𝑔ℎ − 𝑟𝑙𝑜𝑤
331,194.5464 − 300,000
= 0.0033 + × 0.005833 − 0.003333
331,194.5464 − 258,044.92
= 0.0033 + 0.001067 ≅ 0.004367
• Therefore, Quoted rate 𝑄 = 𝑟 × 12 ≅ 5.24%
LOAN BALANCE
• The remaining balance on a fixed-payment loan is the PV of the
remaining payments.
• A 30-year mortgage. The monthly payment is $1,000. The quoted rate
is 7% (monthly rate, r = 7% / 12 = 0.5833%), 𝑛 = 360, 𝑃𝑀𝑇 = 1,000.
• Calculate PV:
1 − 1 + 𝑟 −𝑛 1 − 1.005833 −360
𝑃𝑉 = 𝑃𝑀𝑇 × = 1,000 ×
𝑟 0.005833
= 1,000 × 150.39098 ≅ 𝟏𝟓𝟎, 𝟑𝟗𝟎. 𝟗𝟖𝟓𝟔
• What is the loan balance at the end of 5 years? The remaining months
= 360 – 60 = 300.
1 − 1 + 𝑟 −𝑛 1 − 1.005833 −300
𝑃𝑉 = 𝑃𝑀𝑇 × = 1,000 ×
𝑟 0.005833
= 1,000 × 141.4920 ≅ 141,492.01
DISCOUNT POINTS
• The actual interest payments of a loan to the lender are usually
higher than the quoted rate would suggest.
• Discount points: advance amount the lender charge at the
beginning of the loan contract. By paying upfront, the borrower can
secure a lower interest rate, which can result in lower monthly
mortgage payments.
• The decision to pay discount points depends on various factors,
including the borrower's financial situation and how long they plan
to stay in the home.
• For example, in the previous example, if the lender charges
discount points in the amount of $5,390.9856. Then the actual
payout to the borrower is $145,000.
($150,390.9856 – $5,390.9856 = $145,000).
LENDER’S YIELD (LY)
• Lender's yield: the rate of return that a lender earns on a loan,
considering both the interest rate and any fees or charges associated
with the loan.
• It is typically higher than the interest rate on the loan, as lenders
can earn additional income from fees and charges.
• 𝑃𝑉 = 145,000 (𝑎𝑑𝑗𝑢𝑠𝑡𝑒𝑑 𝑓𝑜𝑟 𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝑝𝑜𝑖𝑛𝑡𝑠), 𝑃𝑀𝑇 = 1,000, 𝑛 = 360.
• We need to calculate monthly coupon and then convert it to yearly
coupon using the interpolation method as earlier. Calculation finds
that value of 𝑟 ≅ 0.6133%.
• That is, 𝑅 = 0.6133% × 12 ≅ 7.36%
• Which is greater than the quoted rate of 7%.
• Here, we assume no prepayment so that N is 360.
EFFECTIVE BORROWING COST (EBC)
• Effective borrowing cost: the true cost of borrowing money,
considering not only the interest rate but also any fees, charges, and
prepayment penalties associated with the loan.
• It is a more accurate measure of the cost of borrowing than the
interest rate alone, as it includes all the costs associated with the
loan.
• In addition to quoted rate and discount points, the borrower needs to
incur other costs at the closing, called closing costs, such as title
insurance, appraisal fee, etc.
• Suppose that the closing costs are $2692. Then, the actual loan
received by the borrower is $145,000 – $2,692 = $142,308.
• 𝑃𝑉 = 142,308, 𝑃𝑀𝑇 = 1,000, 𝑛 = 360. Calculate 𝑟.
• The answer is: 𝑟 = 0.6292. EBC = 0.6292× 12 = 7.55%.
USUAL UP-FRONT FINANCING COSTS
• Discount points (fees paid by borrowers to lenders at the time of closing in
exchange for a lower interest rate on a mortgage loan.).
• Loan origination fee (loan documents preparation, and other
administrative costs).
• Appraisal fee (determination of property value).
• Credit check (information about credit accounts, loans, credit cards,
payment history, outstanding debts, unpaid taxes and bankruptcies).
• Title insurance (protects property owners and lenders against financial
losses resulting from defects or issues related to the ownership of a
property).
• Mortgage insurance (protects the lender in case the borrower defaults on
their mortgage payments).
• Recording fee (covers the cost of processing, indexing, and maintaining
these records by the government agency responsible for recording).
• Survey costs (measurement and mapping of a piece of land, including its
boundaries, dimensions, and other relevant features); Etc.
ANNUAL PERCENTAGE RATE (APR)

• Annual percentage rate (APR) is a measure of the total cost of

borrowing money, expressed as a yearly percentage rate.
• By law, lenders are required to disclose the APR for any loan they
offer. This allows borrowers an accurate way to compare different
loan offers from different lenders.
• It includes not only the interest rate on the loan but also any other
fees or charges that the borrower may be required to pay, such as
origination fees, closing costs, and points.
PREPAYMENT

• Prepayment is the norm for residential mortgages; households

sell their homes frequently.
• The calculations of LY and EBC are sensitive to when a
prepayment may happen.
• Note that the LY and EBC calculations we discussed so far do not
assume of any prepayment.
 PREPAYMENT IMPACT ON LY & EBC
• When a borrower prepays a loan, it can affect both the lender's
yield and the effective borrowing cost.
• If a borrower prepays a loan, the lender's yield may be lower than
anticipated (lenders can avoid this by using discount points) , as
the lender is not able to earn as much interest on the loan.
• At the same time, the effective borrowing cost for the borrower
may be lower (not when discount points are used), as they are able
to pay off the loan more quickly and reduce the amount of interest
they will ultimately pay.
• It's important for borrowers to consider all these factors when
deciding whether to prepay a loan, as it can have a significant
impact on the overall cost of borrowing.
 PREPAYMENT WITH LY & EBC
• A home mortgage loan rarely survives to maturity. Homeowners
may move, or they may simply wish to take advantage of lower
interest rates; therefore, they replace their current mortgage
loan.
• Suppose that our example loan is expected to be paid
off at the end of 7 years. What does this prepayment do to the
lender’s yield and the EBC?
• The loan balance at the end of seven years, equal to the present
value of the remaining 276 payments, is $137,001.46.
1− 1+𝑟 −𝑛 1− 1.005833 −276
𝑃𝑉 = 𝑃𝑀𝑇 × = 1000 × ≅$137,006
𝑟 0.005833
 PREPAYMENT WITH LY & EBC…

• So, if a lender originates this loan with a net disbursement to the

borrower at closing of $145,000, the computation of lender’s yield
would be:
• Now, calculate r for 𝑛 = 84, 𝑃𝑉 = 145,000, 𝑃𝑀𝑇 = 1,000, 𝐹𝑉 =
137,006, you will find 𝑟 = 0.6399
=Rate(nper, pmt, pv,-fv)
=RATE(84,1000,145000,-137006) >> Excel function
• 𝐿𝑌 = 𝑟 × 12 = 0.6399 × 12 ≅ 7.68% > 7.36% (LY with prepayment).
 EBC WITH PREPAYMENT
• Similarly, a prepayment would increase the EBC.
• The loan balance is $137,006.
• The actual proceed received by the borrowers after discount points and
closing costs is $142,308.
• Calculate rate for 𝑛 = 84, 𝑃𝑉 = 142,308, 𝑃𝑀𝑇 = 1000, 𝐹𝑉 = 137006
=RATE(84,1000,142308,-137006) Excel input  0.6695.
EBC = 0.6695× 12 = 8.03% > 7.55% (EBC with prepayment).
• In general, whenever a lender charges “up-front” points/ other fees
on a loan, the earlier the loan is paid off, the higher is the lender’s
yield.
• For the same reason, since a borrower virtually always faces up-front
expenses in obtaining a mortgage loan, the earlier the borrower pays
off the loan, the higher is the EBC, all else equal.
 ALTERNATIVE AMORTIZATION SCHEDULES
• Interest-only (straight term) mortgages: Interest-only mortgages
are repaid in full with one payment on maturity of the loan.
• During the life of the loan, however, borrowers make only interest
payments periodically (e.g., monthly).
• For example, assume the borrower and the lender agree to a
$250,000, 7-year, interest-only loan at 6%.
• The monthly payment is $1,250 (0.06 ÷ 12 ×250,000).
• If the loan were to be fully amortized over 30 years, the monthly
payment would equal $1,498.88 because it includes principal.
• Unlike the amortizing mortgage, the loan balance on the interest
only loan would remain constant at $250,000.
ALTERNATIVE AMORTIZATION SCHEDULES…

• Partially Amortizing Mortgages: Partially amortizing mortgage

loans require periodic payments of principal, as well as interest.
• But they are not paid off completely over the loan’s term to
maturity. Instead, the loan has an amortization term longer than
the term to maturity.
• For example, assume the $250,000, 6% loan would be amortized
over 30 years, but the term to maturity is 7 years. The monthly
payment is $1,498.88 and the remaining mortgage balance at the
end of year 7 would equal $224,098.
ALTERNATIVE AMORTIZATION SCHEDULES…

• The borrower at that time must either

(1) negotiate a new $224,098 loan with the original lender at current
rates,
(2) negotiate a loan with a new lender and use the proceeds to pay
off the original lender, or
(3) sell the property and use the sale proceeds to pay off the original
lender.
 ADJUSTABLE-RATE MORTGAGES (ARMS)
• An adjustable-rate mortgage (ARM) is a type of mortgage loan in which
the interest rate can fluctuate over time.
• Unlike a fixed-rate mortgage, where the interest rate remains constant
throughout the loan term, an ARM has an initial fixed-rate period,
followed by a variable rate period.
• To understand all the features of the mortgage, we need to first become
acquainted with the following terminology:
• The Number System: Most ARMs have a number associated with them
such as 7/1, 5/1, or 3/1. The first number refers to the number of years in
the initial period during which the interest rate cannot change.
• The second number refers to the length of time between subsequent
readjustment periods. So, a 2/1 ARM will have a fixed rate for the first two
years, after which the rate can be adjusted once every year.
ADJUSTABLE-RATE MORTGAGES (ARMS)…
• The Margin: Think of the margin as an initial markup (expressed
as a percent) that is added to the stated interest rate. So, a 5% ARM
with a 2% margin will actually cost you 7% at the very beginning of
the mortgage.
• The Cap: The periodic adjustment cap is the size of the adjustment
that can be applied to the mortgage during any one adjustment
period. To illustrate, suppose that the annual cap is ¾% on a 30-
year 2/1 ARM.
• That means the interest rate on the mortgage can be increased or
decreased by a maximum of ¾% in each of the 3rd , 4th , and
through 30th years of the mortgage.
ADJUSTABLE-RATE MORTGAGES (ARMS)…
• The cap (contd.): However, a lifetime cap, also known as a ceiling
(if the rate goes up), or a floor (if the rate goes down) limits to the
maximum adjustment that can be applied to the initial interest
rate.
• So, the interest rate on a 5% ARM with a 2% margin and a 6%
lifetime cap can never become larger than 13%, or smaller than 1%.
• That is, if the index goes up (or down) 1% from one adjustment
period to the next, the ARM will also be adjusted by the same
amount unless limited by the cap.
• The Index: The index is a published interest rate series – usually
based on T-Bill yields or the LIBOR rate (the rate at which banks in
London borrow from other banks) – that is used to adjust the ARM
rate.
ADJUSTABLE-RATE MORTGAGES (ARMS)…
• LIBOR has been subject to manipulation, scandal, and methodological
critique, making it less credible today as a benchmark rate. LIBOR has
been replaced by the Secured Overnight Financing Rate (SOFR) on June
30, 2023.
• Finally, some lenders offer a “teaser,” “start,” or “discounted” rate that
is lower than their fully indexed rate. When the teaser rate ends, your
loan takes on the fully indexed rate.
• Borrowers often choose an ARM when they expect to sell the property or
refinance before the end of the initial fixed-rate period. ARM loans can
provide lower initial rates and payments, but they also involve more
uncertainty as the rate can go up or down in the future.
 ARM EXAMPLE 1
• A 1-year $100,000 ARM with a 30-year amortization. The index rate
is 1-year T-bill rate, which is 2% (200 bp) now. The margin is 2.75%
(𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 = 𝑖𝑛𝑑𝑒𝑥 + 𝑚𝑎𝑟𝑔𝑖𝑛 = 2% + 2.75% = 4.75%). The teaser rate
is 3.25% for the 1st year.
Initial amount = $100,000 Caps: None
Term: 30 Yrs. (360 Months)
Margin: 2.75% (275 bp)
Beginning of Yr.
1 2 3
Index 2.00% 2.00% 2.25%
Teaser rate 3.25% --- ---
Interest rate 3.25% (2.00+2.75)% (2.25+2.75)%
Loan balance $100,000 $97,997.88 (PV formula, $96,387.43 (PV formula,
n=348) n=336)

Months remaining 360 348 336

Monthly payments $435.21 (PMT formula) $519.22 $533.58
ARM EXAMPLE 2
Despite the popularity of the one-year ARM, many borrowers prefer
longer initial adjustment periods. For example, with a 3/1 ARM, the
interest rate is fixed for 3 years and then adjusts annually thereafter.
Initial amount = $100,000 Caps: • Whether the rate
Term: 30 Yrs. (360 Months) Periodic: 1% (annual) change from the 1st
Margin: 2.75% (275 bp) Overall/lifetime: 5%
year to the 2nd is
Beginning of Yr.
constrained by the
1 2 3
periodic cap depends
Index 2.00% 2.00% 2.25%
on how the note is
Teaser rate 3.25% --- --- written.
Interest rate 3.25% Lesser of Lesser of • The cap may be applied
(2.00+2.75)% or (2.25+2.75)% or to the teaser rate, or it
(3.25+1.00)% (4.25+1.00)%
Assumes the periodic cap may be applied only to
the index plus margin.
applies to the “teaser” rate.

Loan balance $100,000 $97,997.88 $96,387.43

• ARM loans may be
Months remaining 360 348 336 written with both
Monthly payments $435.21 $519.22 $533.58 arrangements.
 LPMS VS. ARMS: RISK

• The use of rate caps in an ARM loan shifts the risk between the
borrower and the lender.
• If interest rates rise in an LPM, the borrower’s payments are
unaffected, while the value of the lender’s asset (the loan) falls
because the market now discounts the loan’s payment stream at a
higher discount rate.
• If short-term Treasury rates rise in an unconstrained ARM, so
does the borrower’s payment, protecting the value of the lender’s
mortgage asset, at least to some extent.
 LPMS VS. ARMS: RISK
• Thus, the LPM places the bulk of the interest rate risk of the loan on
the lender.
• While an unconstrained ARM does much the opposite.
• Caps, on the other hand, reallocate interest rate risk someplace
between these extremes.
• The shift of interest rate risk back to the lender when tight caps are
included is a cost to the lender. How do lenders balance the pricing
of ARMs with rate caps relative to ARMs without such caps?
• They must, increase their expected return on the ARM with caps.
Thus, borrowers who choose ARMs with rate caps can expect a
higher initial contract interest rate, a higher margin, more up-front
financing costs, or some combination of the three.
 REFINANCING

• The borrower may refinance after interest rate falls.

• Whether to refinance is a very complex investment decision
because refinancing is not a one-time decision.
• You can refinance later (say, 1 year later) when interest rate could
be lower, instead of doing it today even though doing it today
seems to be a good deal compared with the existing loan.
• Timing option.
REFINANCING EXAMPLE

• Suppose that Alan has an existing loan with a remaining term of 15

years, a remaining balance of $100,000, and an interest rate of
7%. The existing monthly payment is $898.83.
• Alan can refinance the loan for $100,000, the same 15 years, for
5%. But the up-front refinancing costs (fees) are 5% of the loan
amount, i.e., $5,000.
 REFINANCING EXAMPLE…

• If Alan goes for refinancing, the monthly rate is 5 / 12 = 0.4167%.

• Suppose the $5000 fee is not amortized. The monthly payment is:
𝑛 = 180, 𝑟 = 0.4167, 𝑃𝑉 = 100,000 PMT  790.81.
• The reduction in monthly payment: 898.83 – 790.81 = $108.02.
• Suppose that Alan can earn 6% on the $108.02 saving.
• If Alan expects to sell his house in 8 years, the PV of the expected
benefits of refinancing is: 𝑛 = 96, 𝑟 = 0.5, 𝑃𝑀𝑇 = 108.02, PV 
8,219.8055.
 REFINANCING EXAMPLE…

• Suppose that Alan has a 20% marginal income tax rate.

• The NPV of refinancing after tax is: (8219.8055 × (1 – 20%)) –
5000 = $1,575.884.
• NPV > 0, so refinancing is not a bad idea.
• We focus on NPV after tax because mortgage interest payments
are tax deductible; the existing loan has higher interest expense
and higher tax benefits than the new (refinancing) one.
REFINANCING EXAMPLE…

• Suppose that Alan also expects that the interest rate will drop
from 5% to 4% in 1 month.
• In 1 month, the existing loan has a remaining term of 14 years
and 11 months. The interest rate on the existing loan is 7%. The
existing monthly payment is $898.83.
• Thus, the remaining balance in 1 month is: n=179 ; r=0.5833;
PMT=898.83; PV  99,687.1661.
REFINANCING EXAMPLE…

• The new monthly payment is: n=179; r=0.3333; PV= 99,687.1661

PV; PMT  740.36.
• The reduction in monthly payment: 898.83 – 740.36 = $158.47.
• Alan can earn 6% on the saving and expect to sell his house in 7
years and 11 months.
• The PV of the expected benefits of refinancing is: n=95; r=0.5;
PMT=158.47; PV 11,960.63.
REFINANCING EXAMPLE…

• The NPV of refinancing after tax is: (11960.63 × (1 – 20%)) – 5000

= $4,568.50.
• This NPV is higher than that of financing now $1,575.884.
• Thus, Alan will prefer to wait even though the NPV for acting
today is positive.
• Is it optimal for Alan to refinance twice: now and 1 month later?
 RULE OF THUMB

• A widely used rule of thumb by practitioners and news media is

that: refinance when the interest rate spread between existing
loan and a new loan reaches about 2%.
• Of course, this rule of thumb is very rough.
 FEE PAYING OPTIONS
• 3 main options for paying refinancing fees:
(1) pay the fees up front, most straightforward option is to pay the
refinancing fees directly from your own funds.
(2) rolled into the loan: another option is to roll the refinancing fees
into the new loan amount. Keep in mind that by rolling the fees into
the loan, you'll be paying interest on them over time, which will
increase the overall cost of the loan.
(3) lender credits: some lenders may offer a lender credit as an
incentive to choose their refinancing services. With a lender credit,
the lender covers a portion or all the refinancing fees in exchange
for a slightly higher interest rate.