Question

Hello, would anyone be so kind to explain, without using a calculation, what the decisive variable is that drives the decision to refinance a mortgage?

Answer 1

Any mortgage is an agreement between a borrower and a lender which entails the lender paying the borrower a lump sum amount at a point in time, followed by the borrower paying back the borrowed amount to the lender over a prefixed period of time through pre-fixed periodic repayments. These repayments consist of two parts, the first part pays back a portion of the amount originally borrowed and the second part is a cost of using the lender's fund (in the form of borrowing). The second part which is the cost for using the lender's fund is known as the interest payment and is dependent on the interest rate. For a borrower, the first part remains largely unaltered by any factors during the mortgage repayment period. However. the interest payment part can be changed owing to it being dependent on the interest rate. In fact, if interest rates go down during the period of mortgage repayment, the borrower is essentially paying more interest as his/her interest rate is usually fixed at the time of mortgage issue. Hence, it is natural for the borrower to refinance his/her mortgage so as to benefit from the now lower interest rates and hence lower interest payments. Therefore, the interest rate on the mortgage and contemporary market interest rates (during the mortgage repayment duration) are the key variables that drive mortgage refinancing decisions.

NOTE: The mortgage NPV is the gains made by refinancing an existing mortgage at a new lower interest rate. The NPV of a mortgage is the interest savings(owing to refinancing at a lower rate) less any refinancing costs. Any NPV which is positive should drive a person to refinance his/her mortgage as the same leads to positive tangible savings in the form of interest costs saved. Hence, a positive NPV of refinancing is a driving force behind refinancing. The mortgage NPV is, however, dependent on the changes in the interest rates (decline in the mortgage interest rate) and hence the solution provided is not incorrect.