This
post describes a problem that I was recently asked to analyze. An applicant
for a mortgage refinance had to choose between refinancing the entire current mortgage
with either a jumbo loan or a small conventional loan and a cash paydown. He needed my advice on what option was best.
Question: A person refinancing a $650,000 30year Adjustable
Rate Mortgage loan into a 15year Fixed Rate Mortgage has two options. The first option involves refinancing the
current $650,000 30year ARM with a $650,000 jumbo 15year FRM. The second option involves reducing the loan
balance by $100,000 and taking out a $550,000 conventional FRM.
Note many people lack an extra $100,000 and don’t have two options.
The advantages of the jumbo loan are greater liquidity and earnings
on the $100,000, which is invested in financial assets.
The advantage of the conventional loan is lower lifetime interest
payments.
Create a spreadsheet to evaluate these two options for base case
assumptions and for modifications to the base case.
The Base Case:
Both mortgages have a 3.75% interest rate,
Invested funds under the jumbo bond option are invested in
Treasury bills and receive a 2.5% rate of return,
The marginal tax rate applied to both investment income and gains
from mortgage interest deduction is 30%.
What option – the jumbo mortgage or the conventional mortgage – is
preferable under the base case assumption?
Alternative Scenarios:
Often conventional mortgage interest rates are lower than jumbo
interest rates. Assume the conventional mortgage interest
rate is 3.25% and the jumbo mortgage interest rate is 3.75%.
What option is preferable?
The investor chooses to invest partially in stock and partially in
Treasury bonds. Accounting for risk, the
certainty equivalent rate of return on invested funds is 6.5%. Assume a 3.25% conventional interest rate and
a 3.75% jumbo interest rate What option
is preferable?
Analysis:
The measure of the most
affordable mortgage is aftertax lifetime
interest costs minus after tax investment income plus
Here is a table describing base case results.
Base Case Results


Jumbo Loan No Paydown

Conventional Loan $100,000 Paydown


Interest Rate

3.75%

3.75%

Loan Term Years

15

15

Paydown Amount

$0

$100,000

Initial Loan Balance

$650,000

$550,000

Invested Cash

$100,000

$0

Interest Rate on Invested Cash

2.50%

NA

Monthly Mortgage Payment

$4,712

$3,987

Mortgage Payments over 15 years

$848,199.63

$717,707.38

Annual Earnings On Cash Invested

$2,500

NA

Cumulative Earnings

$37,500

NA

Mortgage Payments  Cumulative Earnings

$810,700

$717,707

Cumulative Interest

$198,199.63

$167,707.38

Principle

$650,000

$550,000

Total Payments

$848,199.63

$717,707.38

Tax Rate

0.3

0.3

Tax Savings from Deduction of Mortgage Interest

$59,459.89

$50,312.21

Tax Paid on Investment
Income

$11,250

0

After Tax Mortgage Payments Minus After Tax investment Income

$762,490

$667,395

· The
conventional mortgage appears to save the home buyer around $95,000 ($762k $667k
)over fifteen years. This is a bit more than $6,300 per year.
Lower conventional mortgage interest rates
Typically interest rates on conventional mortgages can be lower
than interest rates on jumbo mortgages.
The differential is currently fairly small because demand for large
houses is at this time lower than demand for midsize houses.
The results below pertain to a situation where the conventional
mortgage interest rate is 3.25%, the jumbo mortgage interest rate is 3.75% and
all other variables are set by base rate assumptions.
Lower Conventional Mortgage Rate Results


Jumbo

Conventional

Diff.


After Tax Mortgage Payments Minus After Tax investment Income

$762,490

$650,634

$111,856

Assumed Conventional Mortgage
has 3.25% interest all other assumptions are base case
·
The conventional option appears to save the borrower
close to $112,000 over $9,300 per year.
Lower Conventional Mortgage Rates
A person who takes out the jumbo loan and invests in stocks could
get higher returns. The final scenario assumes a 6.5% return, a conventional
mortgage rate of 3.25%, a jumbo rate of 3.75% and all other variables determined
by the base case.
Higher Returns & Lower Conventional Mortgage Rates


Jumbo

Conventional

Diff.


After Tax Mortgage Payments Minus After Tax
investment Income

$720,490

$667,395

$53,095

· The
conventional option appears to save the borrower around $53,000 or around
$3,500 per year.
Concluding
Remarks: The conventional loan &
pay down option beats the jumbo loan option in all three scenarios considered
here. The jumbo loan option could win
after the fact if borrower buys risky assets and these assets experience large
returns but this scenario does not consider risk.
The best justification for the jumbo loan option would be fear of
losing so much liquidity.
Authors
Note: Please consider my books
on Kindle.
Defying Magnets: Centrist
Policies in a Polarized World.
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Things to Consider Before Purchasing Long Term Care Insurance
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