Tom Miller owns a house that he bought 5 years ago for $200,000. He financed the...

Tom Miller owns a house that he bought 5 years ago for $200,000. He financed the purchase with an 80% LTV loan at 7% interest and a 30-year amortization term with monthly payments.

Interest rates have since fallen and a new loan (which is equal to the balance of the original loan) is now available at 5.25% interest rate with 4 discount points and is amortized over 25 years with monthly payments. Neither mortgage requires a prepayment penalty. Assume that Tom cannot borrow the costs of refinancing.

a. If Tom decides to refinance, what is the required initial investment (cost of refinancing)?

b. What is the difference between the monthly payments of the original mortgage and the new mortgage?

c. Assume Tom plans to hold the new mortgage for 6 years. What is the difference between the balances of the original mortgage and the new mortgage?

d. Assume Tom plans to hold the new mortgage for 6 years and his required rate of return is 8%. Should he refinance?

Expert Solution

a. If Tom decides to refinance, required initial investment (cost of refinancing)= $6,024.42

b. Difference between the monthly payments of the original mortgage and the new mortgage= Reduction by $161.95

c. If the new mortgage is held for 6 years the difference between the balances of the original mortgage and the new mortgage= $ 134,033.52 - $ 130,046.14 = New loan is less by $3,987.38

d. If Tom plans to hold the new mortgage for 6 years, rate of return= 24.91%

Since his required rate of return is 8%, he shall refinance.

Calculations as below:

jeff jeffy answered 2 years ago

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