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Refinancing decisions Real Estate Finance, February XX, 2016.

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Presentation on theme: "Refinancing decisions Real Estate Finance, February XX, 2016."— Presentation transcript:

1 Refinancing decisions Real Estate Finance, February XX, 2016

2  Residential finance Residential refinancing decisions Costs and benefits of refinancing Cash-out refinancing Modeling refinancing behavior Market value Embedded options Prepayment Strategic default Overview

3  A borrower refinances their mortgage when they use the proceeds from a new mortgage to pay off their existing off existing loans Why refinance? If the prevailing rates on comparable mortgage loans are lower than the rate on the borrower’s current loan If the borrower has “cured” their poor credit rating and are able to replace a high cost subprime loan with a lower cost prime mortgage If the value of the property securing the loan has increased, the borrower may choose to take equity value out of the property by increasing the principal amount borrowed Refinancing

4 Refinancing a mortgage typically requires that a borrower pay closing costs and other fees that they are not required to pay if they do not refinance their loan.  Points/origination fees  Closing costs Appraisal Credit report Recording fees  Prepayment penalties Refinancing

5 Refinancing can be analyzed in the same way that we would evaluate an investment opportunity  What is the yield received when taking the required costs into account?  What is the yield that could be obtained by investing the funds elsewhere? Opportunity cost Refinancing

6 Example:  Original loan $250,000, 30-year, fixed-payment mortgage with a 7% contract rate  Potential new loan (5 years later) 6.5%, 25-year, fixed payment mortgage 2 points and $1500 in closing costs Refinancing

7  New loan amount? $235,329.00  Cost of new loan?.02(235,329.00) = $4706.58 Fees of $1500  Benefits of new loan? Difference in payments = 1,663.26 – 1588.96 = 74.30 Refinancing

8 What is the benefit of refinancing?  Determine the yield: The required investment equals points plus other fees The cash flows received from the investment equal the difference in payments produced by refinancing Refinancing

9  Original loan: $250,000@7%, 30-year, fixed-payment mortgage  Potential new loan (5 years later): 6.5%, 30-year, fixed payment mortgage 2 points and $1500 in closing costs Refinancing

10  New loan amount? $235,329.00  Cost of new loan?.02(235,329.00) = $4706.58 Fees of $1500 Addition of five years of monthly payment of 1487.44 that you would not have to pay if you did not refinance  Benefits of new loan? Difference in payments = 1,663.26 – 1487.44 = 175.82 for the next 25 years Refinancing

11  What is the return to refinancing? Does extending the term make a difference? There is an increased benefit due to the lower payment associated with the longer term There is an additional cost as the borrower must now make 5 additional years of payments that he/she wouldn’t have to make if they did not refinance Refinancing

12  Original loan: $250,000, 30-year, fixed-payment mortgage with a 7% contract rate  Potential new loan (5 years later): 6.5%, 30-year, fixed payment mortgage 2 points and $1500 in closing costs Plan to pay off the mortgage in 10 years If you do not refinance, mortgage balance after 15 years of payments based on original loan If you do refinance, mortgage balance after 10 years of payments based on new loan Refinancing

13  New loan amount? $235,329.00  Cost of new loan?.02(235,329.00) = $4706.58 Fees of $1500  Benefits of new loan? Difference in payments = 1,663.26 – 1487.44 = 175.82 Difference in remaining balance = 185,047.16 – 199,502.81 = – 14,455.65 Refinancing

14  What is the return to refinancing? Does a shorter time horizon make a difference? There is an increased benefit due to the lower payment associated with the longer term There is an increased cost as the borrower must now pay off a larger mortgage balance when the loan is retired due to the longer term of the new loan Refinancing

15  Innovation in mortgage structure: Quicken Loans’ YOURgage Pick your term, from 8 to 30 years, all with fixed rates Refinance up to 95% of your home’s value Loan amounts from $25,000 to $417,000 Refinancing

16  If housing values have increased since origination, the value of the borrower’s equity in the home has increased What has happened to the LTV ratio? What has happened to the proportion of housing wealth relative to other assets in the investor’s portfolio? Refinancing

17  Original loan: $250,000, 30-year, fixed-payment mortgage with a 7% contract rate What is home value at origination based on 80% LTV? What is the value of the house if prices have increased by 2% a year for the past five years? What is the homeowner’s return on equity? Refinancing

18  Potential new loan (5 years later): 6.5%, 25-year, fixed payment mortgage 2 points and $1500 in closing costs 80% minimum LTV Maximum loan amount based on LTV is $276,000 Refinancing

19  New loan amount? $276,000.00  Cost of new loan?.02(276,000) + 1500.00 = $7020.00  Benefit of new loan? Refinancing provides an additional source of borrowing for the home owner Difference in payments = 1,663.26 – 1,863.57 = – 200.31 Initial cash flow = 40,671 – 7020 = 33,651 Refinancing

20  What is the market value of future payments associated with mortgage debt? Market value is inversely related to yield  Why should we care about the market value of our debt (or market value of our home) relative to the book value of our debt? Prepayment option Strategic default option Market value

21  250,000 @ 7%, payment equals 1663.26, remaining balance after 5 years is 235,329.00. What is the value of payments if the prevailing rate is 10% 183,036.74 What is the value of payments in the prevailing rate is 5% 284,516.69 Market value

22  An option is a financial agreement allowing the right, but not obligation, to buy or sell a given asset at a pre-specified price on or before a pre-specified date Right to buy: call Right to sell: put Pre-specified price: strike price Asset that can be bought or sold: underlying Options

23 Mortgages offer an embedded call option giving the borrower the right, but not obligation, to purchase the loan from the lender at its book value  What is the underlying asset?  What is the strike price?  When might you want to exercise this option? What are the costs? Points and/or origination fees Opportunity to refinance at a later date when rates may be lower What are the benefits? Purchasing future liabilities at a discount to their market value The option to prepay

24 A non-recourse mortgage loan provides the borrower with an embedded put option by allowing for the sale of the asset securing the loan at a price equal to its book value  What is the underlying asset?  What is the strike price?  When will you want to exercise this option? What are the costs? What are the benefits? A borrower is said to default strategically if they exercise stop making mortgage payments despite still having the ability to service their mortgage debt The option to default


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