Lessons from CFOs: When Refinancing Makes Sense

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When Fortune 500 CFOs contemplate whether or not to refund company bonds, they sometimes ask two questions:

  • How a lot can we save by refunding in the present day?
  • Is that sufficient, or ought to we await extra financial savings?

One query I’m fairly positive they don’t ask: What’s the payback interval?

And but that’s the metric many advisers quote to owners when contemplating whether or not to suggest a refinancing — the variety of years it takes to get better transaction prices with decrease funds.

While payback is straightforward to calculate and appears wise, there are causes fixed-income specialists don’t use it. One is that payback treats a mortgage like an extraordinary bond and utterly ignores the choice worth.

Professionals who commerce mortgage securities discovered years in the past what a foul guess that may be. Simply “dumbing down” a mortgage doesn’t work. You should do the extra sophisticated activity of accounting for the decrease funds that end result when a mortgage holder exercises the choice to refinance.

Wall Street banks and different institutional bond managers have the instruments to deal with this calculation. And whereas their instruments are subtle, what they do is pretty easy: They worth the refinancing choice after which issue that into the mortgage pricing.

Besides being helpful to merchants, this valuation instrument additionally offers a helpful benchmark to CFOs. They can now confirm how a lot of the refinancing choice worth they’re capturing and subsequently whether or not a refinancing is worth it.

The precise benchmark is named “refunding efficiency.” It is an trade metric that measures the ratio of in the present day’s refinancing financial savings divided by the refinance choice worth. A excessive rating — as much as 100% — signifies a “go” advice, whereas a decrease rating is a sign to attend for extra financial savings.

Refunding efficiency was introduced by Andy Kalotay, a Wall Street quantitative analyst and former director at Salomon Brothers. Kalotay has tailored the expertise to the patron mortgage market with the Katolotay Refi Score. The rating works the identical as refunding effectivity by calculating a ratio that may vary between 0%–100% which lets the home-owner know whether or not to refinance now or wait.

For instance, you may run the calculation on an present $100,000 mortgage at 5% curiosity and verify whether or not refinancing at 4.7% is really useful. Factoring in 1.5% transaction prices, in the present day’s refinancing financial savings are $1,804, however the refinance choice worth is $2,045. The ensuing refi rating of 88.2% is beneath the specified threshold, so ready might be the very best recommendation.

Bottom line, the refi rating provides advisers the identical expertise that CFO’s use when pursuing a disciplined technique for harvesting refunding financial savings on company bonds.

How would an adviser clarify the thought of a refinancing rating to a consumer?

In the best state of affairs, the selection is whether or not to refinance in the present day or tomorrow. First, you may calculate in the present day’s refinancing financial savings — the worth of maintaining the present mortgage, the worth of the brand new mortgage, and all transaction prices. And whereas no one is aware of with absolute certainty tomorrow’s refinancing financial savings, you may mannequin them by making an informed guess based mostly on the habits of the actual rates of interest.

Second, you may take tomorrow’s estimated refinancing financial savings, low cost that quantity again to in the present day, and examine it to in the present day’s refinancing financial savings. The increased of the 2 quantities is the estimated most financial savings and likewise the worth of the refinancing choice. From there it’s simple to see, for instance, that the refi rating can by no means exceed 100%.

The refinancing instrument can additionally present why anticipated financial savings don’t rely on a prediction of decrease mortgage charges. In reality, the mannequin assumes that charges have a tendency to remain the identical on common. Savings come from the up-and-down actions of charges and the truth that the choice construction zeros out avoidable refinancing losses.

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All posts are the opinion of the writer. As such, they shouldn’t be construed as funding recommendation, nor do the opinions expressed essentially mirror the views of CFA Institute or the writer’s employer.

Image credit score: ©Getty Images/fandijki

Paul Fennell

Paul Fennell is a finance entrepreneur whose profession spans funding banking at Salomon Brothers and consulting for web start-ups. He developed a structured various to ‘AAA’ municipal bond insurance coverage referred to as Tax Offset Municipal Securities, and his present efforts embody bringing CFO experience to the home-owner’s mortgage financing choice. Fennell obtained his Bachelors diploma from Amherst College, and an MBA from the Tuck School of Business, Dartmouth College.

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