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
