Reference no: EM132796152

One of the most common applications of the payback method relates to the decision to refinance a home loan. When homeowners refinance their mortgage to get a lower interest rate, they must pay up-front costs (referred to as closing costs) to have their home appraised and to cover other transaction costs. They may also pay a small percentage of the new loan amount (referred to as points) to get a lower interest rate. In general, the more points paid up front, the lower the interest rate and the greater the savings down the road. To decide whether or not to refinance or pay additional points, homeowners can compute the payback period by dividing the up-front cost of refinancing by the monthly savings on their mortgage payment.

• For example, if Jim and Sarah are considering paying $2,400 to refinance a loan and reduce their mortgage payment by $150 per month, the payback period would be 16 months ($2,400 ÷ $150 = 16). Unless the couple plans to stay in the home (and not refinance again) for at least 16 months, they should stay with their existing mortgage. Notice that this simple analysis ignores anything that happens after the 16-month payback period.

• For example, what if Jim and Sarah refinanced to a mortgage that had a very low interest rate for two years, but, after those two years, the interest rate would increase dramatically? Or what if the loan had a low monthly payment with a large balloon payment at the end? Should these factors be considered in their decision to refinance? The answer is yes, but the payback method does not consider anything that happens beyond the payback period.

Problem 1: Discuss the limitations of payback period and its effect on decision making.