If your
budget allows for the relatively higher
payment of a 15-year loan, "exchange" your
current loan for the 15 Year Fixed Rate Mortgage.
How
you exchange your 30-year loan loan for
a 15 Year Fixed Rate Mortgage is the next question. There
are many different and valid ways of answering
it.
You could compare loans based
upon total interest paid, before- or after-tax
figures, Internal Rate of Return (IRR),
Net Present Value (NPV), etc. Different
methods evaluate to different numbers,
but any valid method will identify your
best choice.
You could compare loans based
upon total interest paid, before- or after-tax
figures, Internal Rate of Return (IRR),
Net Present Value (NPV), etc. Different
methods evaluate to different numbers,
but any valid method will identify your
best choice.
The
examples below are evaluated using the
Net Present Value (NPV) method of investment
analysis (for a different method of comparing
loans, see Should I pay points or closing costs? NPV is employed
for several reasons.
The function is easily
accessible via a financial calculator or
spreadsheet program. NPV accounts for the
time-value of money, investment risk, and
requires relatively few calculations. Amortization
and calculation of interest are not necessary.
An NPV exists even when the IRR is undefined.
When using NPV, be sure to compare investments
with equal lives.
Simply
put, the NPV is a measure of wealth. When
selecting among several investments, the
investment with the largest NPV should
be chosen. In our examples, the NPVs are
negative. You still select the loan program
with the largest NPV--the one which is
the least negative.
The
first step in calculating NPV is to determine
the amount and "direction" of
the cash flows. In our examples, the loan
amount is a positive cash flow--the borrower
receives it. The payments are negative
cash flows--the borrower pays them.
To
make our job easier, we'll use 15
annual cash flows, not 180 monthly cash
flows. For the first cash flow--the loan
amount--you must account for any loan fee
you might pay. For example, if you get
a $95,000 loan and pay a 1 percent loan
fee ($950) from savings, your first cash
flow is $95,000 - $950 = $94,050.
Hypothetical
Example
Five
years ago you obtained a $100,000, 30-year,
fixed, 8 percent loan with monthly
payments of $733.76. The balance on your
loan is approximately $95,070--call it
$95,000. If you keep this loan, you'll
pay approximately $220,129 over the next
25 years (300 x $733.67).
A quick look
at a new, $95,000, 15-year loan at 7.375
percent shows total principal and
interest payments for 15 years totaling
approximately $157,308. The difference
definitely jumps out at you and you don't
need to go any farther to correctly understand
that a 15-year loan is going to save you
money. The next question is, what is the
best 15 year loan to select?
Four
options are considered.
1) Refinance your
current, 30-year loan for a 15 year loan
and pay the closing costs from savings,
2) Refinance your current loan for a 15-year
loan and finance the closing costs by including
them in your new loan,
3) Refinance your
current loan for a 15-year, zero point
loan,
4) begin paying your current, 30-year
loan as it if were a 15 year loan (rarely
will you incur any penalty for doing this,
but check with your lender first). The
least expensive choice is example one--the
choice with the largest (least negative)
NPV. The interest rates and fees used for
the examples reflect the market differences
between a 30-year and 15-year loan as of
the date of this writing.
| Eg.
1. New 15 Year Fixed Rate Mortgage, 7.375%,
borrower pays 1 point loan
fee from savings. |
| CF
0: Borrower's initial cash flow
= $95,000 - $950 |
$94,050.00 |
| CF
1 - 15: Borrower's annual payment:
($873.93 x 12) |
-
$10,487.13 |
| NPV |
-
$ 7,362 |
| |
| Eg.
2. New 15 Year Fixed Rate Mortgage, 7.375%,
borrower finances 1 point loan
fee. |
| CF
0: Borrower's initial cash flow
= $95,950 - $950 |
$95,000 |
| CF
1 - 15: Borrower's annual payments:
($882.67 x 12) |
-
$10,592.00 |
| NPV |
-
$ 7,427 |
| |
| Eg.
3. New15 Year Fixed Rate Mortgage, 8%, 1 point
rebate pays loan fee. Increased
interest rate required to obtain
1 point rebate. |
| CF
0: Borrower's initial cash flow
= $95,000 |
$95,000 |
| CF
1 - 15: Borrower's annual payments:
($907.87 x 12) |
-
$10,894.43 |
| NPV |
-
$10,198 |
| |
| Eg.
4. Keep current, 8% loan, make
payments based on 15 yr. amortization.
(This is the same as eg. 3.) |
| CF
0: Borrower's initial cash flow
= $95,000 |
$95,000 |
| CF
1 - 15: Borrower's annual payments:
($907.87 x 12) |
-
$10,894.43 |
| NPV |
-
$10,198 |
|
Questions?
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