Question

1. Suppose you own your home, which you purchased 10 years ago with a 30-year FRM at an annual interest rate of 6.5%. Recently, mortgage interest rates have fallen to 3.5%. You’re considering refinancing your home to take advantage of the lower interest rate. What additional information would you need to determine whether it makes financial sense to refinance? Briefly describe how you would make this assessment.

Answer 1

Refinancing the loan because the interest loan would be less would make sense only when the cost of refinancing is taken into account and the net benefit due to refinancing in the form of decreased interest rates is more than the refinancing costs. The homeowner might be required to pay some amount as a penalty for prepayment of the loan. Hence, all these costs will be taken as part of the refinancing costs. Also, as now only 20 years remain on the loan, it might be that the reduced interest payments would be less in number and it might not make sense to refinance it.

To make this assessment, we will enquire about the total refinancing costs. After getting that number, we would calculate the present value of the loan now and with the reduced interest rates. If the difference in these amounts is more than the refinancing costs, we would refinance the loan otherwise not.