• Terms to Know
• Why to Refinance
• Optimal Refinance
• Interest Rate Sensitivities

Terms to Know

• Refinance: to take out a new mortgage and close the existing one. There are fees associated with refinancing, just as there are with taking out a mortgage, and the terms of the new mortgage (including type of mortgage, length of time, and interest rate) can be different from the terms of the previous one.

• Borrowing on Equity: Equity is the difference between the value of the home and the remaining balance of the loan. Borrowing on equity means that you can take extra money out when you refinance--you can open a new loan for a larger amount than the former loan, and the amount of equity built up will decrease.

• Basic Mortgage Terms

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Why to Refinance

There is a wide variety of reasons to refinance, and it is impossible to list every single one, because they are often personal to individual people. There are, however, some circumstances that make refinancing a good idea strictly financially.

One of the most common reasons that people refinance is simply to lower the monthly payment. This could happen in one a few ways: if the refinance causes a longer term or a lower interest rate, the payment could decrease.

Other times, people want to shorten the term of the mortgage. Through refinancing, they could change from a 30-year mortgage to a 15-year mortgage. They could do this to finish paying off the mortgage sooner.

The focus of this study, however, is on a third reason for refinance: to increase a person's net present value. A mortgage payment is initially set so that a person's net present value is equal to zero. Refinance gives a person the opportunity to change this. If the interest rate is low enough, in comparison with the previous interest rate and the fees charged for refinance, a person could increase his net present value. In this case, because of the time value of money, they have ended up paying less than what they received in the loan.

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Optimal Refinance

Optimal simply means the best available, the most advantageous under the restrictions that cannot be changed. An optimal refinance, therefore, is a refinance that gives you the the best financial situation possible. If a refinance causes someone's net present value to decrease, they have not put themselves in a better financial situation, and so it was not an optimal refinance. (Because it is also very common to desire a lower monthly payment, rather than an increased net present value, a refinance that lowers the monthly payment could also be considered optimal.)

What makes an optimal refinance? There are several factors that combine to determine whether or not a refinance is optimal. If the interest rate is lower, that does not automatically mean that the net present value will increase; it is possible that the other factors will overcome the lower interest rate. For example, the interest rate might be 0.5% lower, but if a person changes from a 15-year loan to a 30-year loan, or if a person has to pay thousands of dollars in closing costs, the net present value might decrease. The length of time, the interest rate, fees, and amount borrowed from equity can all affect whether a refinance is optimal.

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Interest Rate Sensitivities

Interest rate sensitivities are a study of how sensitive interest rates are to change. The interest rates talked about here are the optimal interest rates, or the interest rates needed for an optimal refinance. So the question asked in looking at interest rate sensitivities is, how much lower will the optimal interest rate have to be if the beginning balance of the loan is raised by $10,000, the initial interest rate is raised by 0.1%, or if a person waits one extra year before refinancing.

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