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Impact on Net Worth with Loans and Refinancing

Aug 7, 2008
Our society is a debt-based one, all but forcing us to rely on loans or lines of credit to get the things that everything else has and feel accepted, be it car or home loans, credit cards or schooling loans. Business and governments often operate under debt as well, making this anything but a personal financing issue. The real question is not so much will you get in debt at some point, but rather how can you avoid getting into too much debt. In this article we'll look namely at home mortgages and how they play into the whole concept of positive leverage.

Your mortgage is not just a monthly payment, it's a form of leverage to finance an asset for potential future gains. A mortgage is calculated as a liability on a home owner's balance sheet, reducing the remaining value owed from the household's net worth, which includes the full value of the house. Refinancing one's mortgage is a popular choice than lower the monthly payments owed, but this can negatively affect the total net worth of the household.

What refinancing does is reduce the monthly payments in exchange for an upfront fee. Logically this can make sense when a family is going to be living in the home for years to come. The equation of how long the person would have to stay in the home before the savings outweigh the cost is called the payback period. If the payback period is 20 months, then after that 20 month period, the savings to that point would have made up for the refinancing cost, with all future savings being a bonus.

Your net worth does suffer in this transaction though, for two reasons. The first is that the initial cost of refinancing is a liability that immediately lowers your net worth, with all other things remaining constant. The goal is obviously to make up for that initial liability over the longer term, but until that point your net worth is lowered.

Secondly, refinancing a mortgage into a longer term can actually increase your costs over the full length of the mortgage, or even them out at the very least, giving you no gains at all.

Now over the long term these concerns may not prove of much concern at all, but for the purposes of generating a true payback period in the event that you may not be staying in the home for the long haul, there is a much better approach that can be taken to calculating this, through the old and new mortgages amortization schedules.

Firstly the cost of refinancing is included in the amortization schedule of the new mortgage, and subtracted from the principal balance of the old one, under the theory that the money could instead have been used to pay down the principal of the existing loan. The difference in monthly payment savings should also be reduced from the new mortgage for the same reason as above, that it could be used to pay down the principal. Now you can get a true sense of the real payback period of refinancing.

What you'll find in most cases is that the real payback period is significantly longer than the payback period appears under the simpler method of calculation, 50% longer or more.

This approach takes a bit more work, but amortization calculators are available through many websites, and these can be used to help you with the calculations. By taking this approach, you can avoid seriously hurting your potential net worth and credit report by refinancing under the wrong circumstances.
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