I just heard some ridiculous financial advice from a “personal finance guru” regarding refinancing your home mortgage.

  1. Refinance to a lower interest rate.
  2. Refinance to a shorter amortization term (number of payments to pay off).
  3. Refinance only when you can recover the closing costs during the time that you will stay in the home. That is, divide the closing costs by the monthly savings to calculate the number of months to stay in the home to recover the closing costs.

Now these seem like good ideas for financially illiterate folks. Let’s take a closer look at them in relation to the principles of Time Value of Money (TVM).

Number 1 seems good, in general. However, you must consider it in relation to number 2, the amortization term. The interest rate and the amortization periods combine to calculate the Periodic Debt Constant (PDC). Multiply the PDC by the number of payment periods per year to calculate the Annual Debt Constant (ADC). Multiply the debt constant by the loan amount to calculate the debt service.

In the Guru’s example, the 30-year fixed rate is annual 3.80%, and the 15-year fixed rate is annual 3.08%. The 30-year ADC is 5.59%, and the 15-year ADC is 8.33%.

The higher debt constant for the 15-year loan means a higher monthly payment, but you’re saving 15 years of interest. What the Guru doesn’t say is that you can get a 30-year loan with 5.59% ADC and choose to make the 8.33% ADC payments. If your financial situation gets tight, you can cut back to 5.59% ADC payments without jeopardizing your equity. If you get a 15-year loan and cannot make the payments, then you are risking default and a foreclosure will wipe out your equity.

If you get a 30-year loan (with no prepayment penalty) and make the higher payment, then it will amortize faster just like the 15-year loan. However, you have the option of reducing the payment to the 30-year payment to give you some time to recover from a cash flow problem. Just get a financial calculator, like the Hewlett-Packard HP 10bII, plug in the Present Value (PV) as the total loan amount, a future value (FV) of zero, the interest rate, and then you choose the amortization periods (TERM), then calculate the periodic payment (PMT). The best choice is to get an “interest only” loan with a 30 year  (or longer) maturity date, then calculate an amortizing payment (amortization term is less than the maturity) that you can afford. You then have the option to reduce your monthly payment to “interest only” to protect your equity when your financial situation gets tight.

During the “interest only” timeframe, your loan amount will not change. It’s like stopping the amortization clock, but the loan remains “current” and not in default. When your financial situation recovers, just recalculate the new payment amount to get back on schedule with your desired amortization term.

Suppose you could get an interest only loan, due in 30 years, at a fixed rate of annual 2.80% with no prepayment penalty? The annual debt constant is 2.80% (it’s interest only with no principal reduction). Then you would have a greater spread between the minimum required payment and the 15-year payment. You could choose interest only when you are tight on funds, then upgrade to a 30-year amortizing payment, or upgrade to a 15-year amortizing payment, or even 12-year or 10-year amortizing payment, depending on your financial situation. You can always drop back to the interest only payment when you are tight on funds, and still protect your equity.

As of this writing, “interest only” loans carry the lowest interest rate compared to amortizing loans. You will need to shop around for a loan that has the longest possible maturity date, no prepayment penalty, and beware of “option to call” provisions that allow the lender to call the loan due before the maturity date.

The number 3 rule about closing costs doesn’t make any financial sense, because it presumes that the payment savings are used to amortize the closing costs at 0.00% yield. You should instead look at the payment savings relative the present value (PV) of the closing costs to determine your return on investment (yield) on refinancing.

I always recommend that you consider rolling-in the closing costs to the new loan amount, especially when you can get a lower monthly payment with the same or shorter amortization term. If you must pay out of pocket for an appraisal, then negotiate to get reimbursed for that cost (cash back at closing).

Let’s say you refinance $300,000 (PV) from 5.50% 30-year to 3.80% 30-year and roll-in 2% closing costs ($6,000) into the new PV ($306,000). Your monthly payment drops from $1,703 to $1,426 (a savings of $277 per month). Your debt will amortize over 30 years (360 payments) just like the previous loan parameters, but you can pocket an extra $277 per month. Suppose you invested $6,000 to receive $277 per month over 3 years (36 payments). Your annualized yield on that investment is 36.64%. If you sell the house before the 3 years, then the buyer will pay off that loan or otherwise assume responsibility for paying it. Either way, it’s a good deal for you at a high yield for monthly cash in pocket, with no out of pocket investment in the first place! (Your yield is actually infinite!)

These examples assume that your Private Mortgage Insurance (PMI) payment doesn’t change after the refinance. Otherwise, you must account for the change in PMI. PMI is usually required when the loan amount exceeds 80% of the appraised value.

You can use the savings to accelerate paying off higher cost personal debt, or to accumulate an investment fund to buy leveraged positive cash flow assets. Buying leveraged positive cash flow assets will help you to pay down your bad personal debt. (See my Power Debt Plan product at http://bit.ly/pdpmmk1 for more information about applying good debt to pay off bad debt.)

Or you can choose to continue paying $1,703 per month and pay off the debt in 266.2 payments (22.18 years saving 7.8 years). None of this has anything to do with how long you intend to stay in the house, because the loan “doesn’t care” how long you want to stay in the house.

This is just the application of simple Time Value of Money (TVM) principles.