Owners of residential or commercial real estate use a similar method to analyze their refinancing decisions. In residential real estate the conventional wisdom applies the "2-2-2 rule": if interest rates have fallen two points below the existing mortgage, if the owner has already paid two years of the mortgage, and if the owner plans to live in the house another two years, then refinancing is feasible. However, this approach ignores the present value of the related cash flows and the effects of the tax deductibility of interest expense and any related points. Therefore, a better analysis of a mortgage refinancing decision should be conducted as follows:

1. Calculate the present value of the after-tax cash flows of the existing mortgage;
2. Calculate the present value of the after-tax cash flows of the proposed mortgage;
3. Compare the outcomes and select the alternative with the lower present value.

The interest rate to be used in steps one and two is the after-tax interest cost of the proposed mortgage. Paying off an existing loan with the proceeds from a new loan, usually of the same size, and using the same property as collateral. In order to decide whether this is worthwhile, the savings in interest must be weighed against the fees associated with refinancing. The difficult part of this calculation is predicting how much the up-front money would be worth when the savings are received.

Posted by karthika on Saturday, July 14, 2007 at 12:21 AM | Permalink