What's my rate? It looks like I gotta WACC you !

You told me "I never want to refinance my 30 year fixed rate loan at 5.25% !"

I told you that I was gonna WACC you if you said dat!

I often use a formula to analyze a client's borrowing costs that is taken straight from a Corporate Finance textbook.  It's called the Weighted Average Cost of Capital or WACC for short. 

I'll give you a brief explanation, in layman's terms, of how I perform a WACC analysis.    Assume these folks have a $350,000 first mortgage at 5.25%, a HELOC of $100,000 8.5%, and consumer debt of $50,000 at 12%.

1- I total up the amount of your debt.  ($350,000 + $100,000 + $30,000= $500,000)

2- I determine what percentage of the total debt each individual loan is :
    a- First Mortgage         ($350,000/$500,000= 70%)
    b- HELOC                     ($100,000/$500,000= 20%)
    c- Consumer Debt         ($50,000/$500,000= 10%)

3- Now, I "weight" each interest rate you pay for a before tax average cost of capital:
    a- First Mortgage         (5.25 * .7= 3.675)
    b- HELOC                     (8.5 * .2 =  1.7)
    c- Consumer Debt         (12 * .1 = 1.2)

4- Add up the weighted rates (3.675 + 1.7 + 1.2 = 6.575)

5- So , the REAL, before tax, cost-of capital for this client is really 6.575%

CAN YOU GET A FIRST MORTGAGE WITH A RATE BETTER THAN 6.575% ?

So, you said, "Yeah, but what about my tax benefits? "

And I replied (as I always do), "Let's plug them into the formula !"

Assume the client is in the 40% marginal tax bracket (for Federal and State taxes). 

1- The total debt remains the same ($500,000)

2- The percentages of total debt remain the same as the above example

3-  Now, I determine the after-tax interest rate for each piece of debt:
     a- First Mortgage=     (5.25% * .6) = 3.15% after tax
     b- HELOC=                 (8.5% * .6) = 5.1% after-tax
     c- There is no tax deduction for the consumer debt so it remains 12% after-tax.

4- Weight the after tax costs:
    a- First Mortgage=      (3.15% * .7= 2.205)
    b- HELOC=                  (5.1 * .2 = 1.02)
    c- Consumer=             (12 * .1= 1.2)

5- The real, after-tax, cost of capital is 4.405%

THAT'S A HELLUVA LOT BETTER THAN 6.575%, RIGHT?

Of course it is.  But you forgot that the new first mortgage has tax benefits, too!  Now you have to translate that after-tax costs of capital. So, we divide 4.405 by .6 and find out that a first mortgage, with a before tax rate of up to 7.34% still makes more sense than keeping that first mortgage.

In this case study, I refinanced them to a 6.25%, 30 year fixed rate loan with an after-tax cost of capital of 4.0%.  Some portion of the new loan may not be deductible due to the Home Equity Interest Deduction Cap of $100,000.  We consulted with their tax advisor, and the new loan still made complete sense.

My point of the article is this:  Stop shopping online for loans.  The average loan hack in a boiler room has no clue about what I just taught you.  Rather, look for a mortgage advisor who has had some real financial planning experience or training.

Here are some pros in your neck of the woods:
Illinois:  Dan Green
Florida:  Robert Ashby
Washington:  Rhonda Porter
Utah: Karl Christen