TVM – What does this stand for and how does it impact you?
There are no shortages of acronyms in the mortgage industry. However, today I’ve borrowed a powerful one from the world of finance theory.
TVM = Time Value of Money
TVM is complex to solve for but relatively straightforward to understand. It behooves us to apply TVM theory in determining whether or not to “buy down” your interest rate.
The Lowest Interest Rate is Not Always the Correct Loan
Isn’t the mortgage with the lowest long-term interest rate always the right choice? Absolutely not. You see, when refinancing it’s typically best practice to build up-front closing costs into the loan amount itself. I’ll use a fictitious example to illustrate:
Assuming a $200,000 loan amount with $5,000 in closing costs, the borrower is faced with 3 typical decisions:
- Finance $200,000 and pay the $5,000 out-of-pocket at closing
- Finance $205,000 and roll the $5,000 closing costs into the loan amount
- A solution somewhere in between #1 and #2
So, which choice is correct for you?
Quite frankly, the answer is “it depends”. I’ll cover the first two options using TVM theory.
- Option 1: Pay closing costs up front thus reducing the loan amount, APR and monthly payment. I’d characterize this as the “highly conservative approach”. In other words, borrowers choosing this option should answer “yes” to all three of the following questions:
- Do you have ample liquid cash reserves for use as emergency funds?
- Will your mortgage interest rate exceed the expected return of your investment portfolio? In other words – a “yes” answer here assumes you could not achieve elsewhere a comparable rate of return to your mortgage interest rate.
- Are you highly confident you’ll live in your home well after the “breakeven point” (explained further below)?
- Option 2: Roll the $5,000 closing cost into the loan. This is the approach I typically recommend. Here’s why:
- I typically advocate for having as much money in “liquid” form as possible. In our example scenario, the borrower often will benefit from having quick access to $5,000 in case of an unforeseen opportunity or emergency.
- Return on investment (ROI). Mortgage funding is often one of the least expensive forms of borrowing. Our concept here, using TVM theory, is to determine if $5,000 in closing costs could yield a better ROI if invested elsewhere. Your financial and/or tax advisor might be able to help you determine how closing costs could be invested elsewhere. If you do not currently work with a financial advisor, and would like me to refer someone, please let me know.
Let’s determine your “breakeven point” together.
This is a very brief analysis we can conduct in approximately ten minutes. Our goal will be to determine a point in time when your refinance “pays you back” and ultimately yields you a profit. The decision regarding closing costs factors into your breakeven point – so let’s dive in sometime soon.
Thanks for allowing me the opportunity to earn your business. I’m here anytime to help guide you through the process.