We’ve often seen consumers go ahead with refinancing mortgages for lowering monthly payments without thinking about its effect on their net worth.
Since a mortgage is an instrument of debt which is used for financing an asset, it appears as a liability on the balance sheet of a household. So to determine the net worth of a household, a mortgage is subtracted from its assets.
So an important question is – does opting for a home refinance actually pay off? Or are you just fixing a bigger problem for a short period?
The Payback Period
Usually the method used to determine whether mortgage refinancing is economical consists of calculating a payback period. For example, if it takes 22 months for the total monthly savings to exceed the refinancing costs, a homeowner will stay with the revised mortgage for at least this period. This method would then consider the refinancing decision as economically wise.
Understanding the Net worth of a Household
A straightforward payback period method however, does not consider the consolidated net worth equation and the balance sheet of the household.
Two primary things aren’t accounted for.
- The relationship between the principal balances of the current mortgage and the new one is ignored. Mortgage refinancing doesn’t come for free. Related costs need to be paid upfront or are clubbed with the principal balance of the new mortgage. So if a refinance transaction results in an increase of a mortgage balance, the liability on a household balance sheet goes up.
When other things remain constant, the net worth of the household promptly comes down by the amount of the refinancing costs.
- If you’re converting a 30 year loan which has 25 years to go into a fresh 30 year loan, you may land up paying a higher interest amount over the new mortgage period, even with a lower rate of interest.
Determining True Refinancing Costs
A better way of determining refinancing economics is by comparing remaining amortization schedules of the current mortgage and the new one. The new mortgage’s amortization schedule will include costs of refinancing as part of the principal balance. When these costs are paid upfront; this amount needs to be deducted from the principal balance of the existing mortgage. After this, deduct monthly payment savings from the new principal balance.
The month during which the revised new mortgage principal balance is lower than the existing mortgage principal balance is when you should be happy. This is the time when you’ve reached a really economically viable refinancing payback period on the basis of household net worth
The Bottom Line
When you calculate the correct economics of your mortgage refinance, you can precisely determine the true payback period you need to deal with if you go ahead.
Figuring out the exact numbers may involve a little hard work, but believe me; it’s well worth it. In case you’re planning to make a shift soon, do spend some time for these calculations. This will probably help you in avoiding damage to your net worth in a big way.
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