Refinancing often seems like a great way to reduce your monthly mortgage payments and leave you with more money for other things. And it can. But when you're weighing the pros and cons, don't forget to consider how this move can affect your net worth. The reason: A mortgage is more than a monthly payment. It is a debt instrument used to finance an asset. And that accounting professor jargon means that having a mortgage undermines your net worth. Here's how that line of reasoning works:

On a household’s balance sheet a mortgage is a liability. As such, it is subtracted from a household’s assets to determine that household’s net worth. Too many consumers fall into the trap of refinancing a mortgage in order to lower their monthly payments without considering how that refinancing affects their total net worth. Does refinancing your home ever pay off? Or is it just a short-term fix to a bigger problem?

The Payback Period

The most popular method for determining the economics of mortgage refinancing involves calculating a simple payback period. This equation is made by calculating the sum of the monthly payment savings that can be realized by refinancing into a new mortgage at a lower interest rate and determining the month in which that cumulative sum of monthly payment savings is greater than the costs of refinancing.

For example, suppose you have a 30-year mortgage loan for $200,000. When you took it out, you got a 6.5% fixed interest rate, and your beginning-of-the-month payment is $1,257. If fixed interest rates now are at 5.5%, this could reduce your monthly payment down to $1,130, making for a monthly savings of $127, which is $1,524 annually. (The typical rule of thumb is that if you can reduce your current interest rate by 0.75% to 1% or higher, it could make sense to consider a refinancing move.)

Next, you’ll need to ask your new lender to calculate your total closing costs for the possible refinance. If they come to approximately $2,300, you know that your payback period would be 1.5 years in the home ($2,300 divided by $1,524 equals 1.5 years). Thus, if you plan on staying in the home for two years or longer, refinancing makes sense, at least according to the simple payback period method.

Refinancing Affects Your Household’s Net Worth

However, this method ignores the household’s balance sheet and the total net worth equation. Two primary things are unaccounted for:

  • The principal balance of the existing mortgage versus the new mortgage is ignored. Refinancing is not free. The costs of refinancing must be paid out of pocket or, in most cases, are rolled into the new mortgage’s principal balance. When a mortgage balance increases through a refinance transaction, the liability side of the household balance sheet increases, and, all other things being constant, the household net worth immediately decreases by an amount equal to the cost of refinancing.
  • Refinancing a 30-year mortgage with 25 years left until it is paid off into a new 30-year mortgage means that you might end up paying more total interest over the life of the new mortgage, even though the interest rate on the new mortgage is lower than the rate you would pay over the remaining 25 years of the existing mortgage.

Look at the Actual Costs of Refinancing

A more financially sound way to determine the economics of refinancing that incorporates the actual costs of refinancing into the household net worth equation is to compare the remaining amortization schedule of the existing mortgage against the amortization schedule of the new mortgage.

The amortization schedule of the new mortgage will include the costs of refinancing in the principal balance. (If the costs of refinancing will be paid out of pocket, then the same dollar amount should be subtracted from the existing mortgage’s principal balance, based on the assumption that if the refinance transaction does not take place, the money you would shell out for costs could instead be used to pay down the principal balance of the existing loan.)

Subtract the monthly payment savings between the two mortgages from the new mortgage’s principal balance. (This is done because, in theory, you could use the monthly savings generated from refinancing to reduce the principal balance of the new mortgage.) The month in which the modified principal balance of the new mortgage is less than the principal balance of the existing mortgage is the month in which a genuinely economical refinancing payback period, one based on household net worth, has been reached.

By the way, amortization calculators can be found on most mortgage-related websites. You can copy and paste the results into a spreadsheet program and then perform the additional calculation of subtracting the monthly payment differences from the new mortgage’s principal balance.

For example, using the above-described calculations, a refinance analysis of an existing mortgage with a fixed interest rate of 7%, 25 years remaining until repayment and a principal balance of $200,000 into a new 30-year mortgage with a fixed interest rate of 6.25% and refinancing costs of $3,000 (which will be rolled into the new mortgage’s principal balance) gives the following results:

If a simple payback period analysis is used to determine the economics of refinancing in the above example, the cumulative monthly payment savings are greater than the $3,000 costs to refinance beginning in month 19. In other words, the simple payback period method tells us that if the homeowner expects to have the new mortgage for 19 or more months, refinancing makes sense.

However, if the net worth approach is used, the refinancing decision would not become economical until month 29, when the principal balance of the new mortgage minus the cumulative monthly payment savings is less than the principal balance of the existing mortgage. The net worth approach tells us that it takes 10 months longer than the simple payback period approach before the refinancing is economical.

Other Factors

Keep in mind that during periods when home values decline, many homes are appraised for much less than they were previously worth. This may cause you to not have enough equity in your home to satisfy the 20% down payment on the new mortgage and require you to come up with a larger cash deposit than expected. It could also require you to carry private mortgage insurance, which will ultimately increase your monthly payment. In these instances, even with the drop in interest rates, your real savings may not amount to much. (For more, see When (and When Not) to Refinance Your Mortgage.)

The Bottom Line

By calculating the actual economics of refinancing your mortgage, you can accurately determine what real payback period you have to contend with. Crunching the numbers takes a bit of work, but anyone can do it.

Especially if you are planning on moving in the next few years, taking a few minutes to calculate the actual economics of refinancing your mortgage may very well help you avoid damaging your net worth by thousands of dollars. And if it does look like refinancing will pay off for you, you will have a much clearer understanding of exactly when you will start benefiting from this move.

Continue Reading