Data is Not Enough

When facing a significant financial decision—such as whether to refinance, buy or lease, or choose between different investments for your small business—having data is very helpful, indeed essential.  But you need a framework with which to evaluate the merits of the data.  You need a framework to weigh pros and cons, make assumptions, and effectively evaluate your decision and goals.  Conversely, having a framework is not enough.  You also need at least some relevant data to back up whatever assumptions and predictions you are making.  No data means you are flying blind. 

You may know how to operate your car, but with no road signs, you’ll likely get lost.  Not knowing how to operate your car on even the most well marked roads, you could end up dead.  Also, it goes without saying to never drive while intoxicated, because your operating skills and ability to interpret the signage are both compromised. 

GDP Growth Aside, Economy Appears Steady and (Slowly) Improving

While data on fourth quarter 2012 GDP growth is disappointing, we should take comfort that are in the midst of a steady recovery, as evidenced by today’s decent economic reports from the ISM and Labor Department.  The economy added jobs, and manufacturing is expanding.  The Fed continues to pump the system with low cost money (in some cases, borrowing rates are lower than the cost of inflation, making it better than free).  Low mortgage rates for refinancing are one method of getting more cash into the hands of consumers. Unfortunately, that avenue has been held back by tighter mortgage underwriting, high unemployment, and other factors, but it is helpful nonetheless.  Here’s hoping that the economy keeps gaining steam for the remainder of 2013.

Refinancing (Part 1)

If you’re a homeowner with a mortgage, you may have an opportunity to lower your monthly mortgage payments.  The ability to fix and perhaps even lower a large portion of your living expenses is a key benefit of home ownership.  (Of course, this must be weighed against some of the negatives, such as property tax, maintenance, and a large, illiquid investment.)  But how do you know if refinancing is a smart decision? 

Mortgages are like bonds.  In financial parlance, a mortgage is an annuity like cash flow stream.  Like a bond, which (usually) disburses interest semiannually (twice a year), mortgages provide cash flow (usually) once per month.  If mortgage rates fall, many homeowners have the option to refinance for lower payments.  If you could lower your payment by $300 per month, that is a bond like stream of income back in your pocket.  You’ve just saved $300 per month.  But there is a cost.  Fortunately, like bonds which provide coupon payments, your $300/month savings can be valued.  This is what is known as the present value of future cash flows.  This is a classic investment decision.  The value of your mortgage savings (or bond), should exceed the cost of refinancing, and other costs as well.  Let’s look at an example.

Barbara financed 80% of the purchase price of her home with a mortgage five years ago.  She borrowed $225,000 in a 30 year fixed rate mortgage at 5.5%, and can now refinance at 3.25%. Is it worth it?  Here are some considerations and numbers she needs to evaluate:

• She should be reasonably certain she will remain in her home for at least 7 years
• Her current monthly mortgage payments are $1,277.53
• She’s been paying for 60 months, and her outstanding principal (assuming she has only paid the actual amount due, not more, not less) is now $208,036.36. 
• Refinancing costs will be $7,500, and she will roll these costs into her new mortgage
• The new rate will be 3.25%
• Instead of paying her mortgage off in 25 years, she will now be back to square one, and her payoff date will be pushed back to 30 years (she is extending mortgage payments an additional 5 years)

If she rolls the closing costs into the equation, she needs to borrow about $216,500 (I rounded up a little from what she actually needs).  Her new payments will be $942.22, for a monthly savings of $335.30.  Every month.  For 25 years.  If this were a bond, this much money received each month would be worth about $68,800.  Think about that.  You can get a bond worth more than $68,000, which pays more than $330 per month for 25 years, for just $7,500.  Of course, that’s not the whole picture.  There is one last cost which is not explicit in this picture.  That cost is the extension of five years of additional payments that the borrower (mortgagee) needs to pay.  We need to calculate this value and deduct it from the value of the savings.  The value today of an additional 5 years of payments of $942, beginning in 25 years, is $23,426.27.  This cost will need to be deducted from the $68,800 value of the savings.  When you also deduct the $7,500 in closing costs, you are still left with a benefit of $37,879.89.  That’s no small amount.  But the real benefit is felt month after month, in the form of $335 of savings, for 25 years.  This is definitely a good deal. 

I’m sure many will have plenty of questions regarding my example.  I plan on revisiting this topic in the future to help clarify the concept.  Feel free to comment and let me know what you think.

Welcome to Hurdle Rate!

This blog is concerned with the use of financial concepts—financial reasoning—to make good choices.  Finance is a discipline with a deep tool kit to assist practitioners in economic decision making.  The purpose of this blog is to help readers understand and utilize these tools.  I hope this blog serves as true investment vehicle, providing healthy returns in the form of financial education for its readers and for myself.  Along the way, I’ll opine on current business and economic topics, books, food and wine, and pop culture.