Weighted Average Cost of Capital Doesn't Include Everything

Or: Figures don't lie, but Liars Sure do Figure!

NOTE: At this update, rates on first trust deed loans are about as low as they have ever been while rates on second mortgages aren't particularly low. However, that won't last forever and we are likely to see a fresh round of this nonsense in the near future. The figures are unchanged from when I originally wrote the article, but it's the attitude that's important.

We've got a lot of people with loans in the low fives, interest rate wise, and we will soon have another wave of people with interest rates in the high fours. Lenders and loan officers need to have someone refinance now in order to get paid. One of the tricks they use to persuade folks with low interest loans to refinance is Weighted Average Cost of Capital, which really does take a page out of corporate finance books, but ignores a lot of details and alternatives.

This was an actual example that someone put online as an argument to refinance:

Current situation:

$350,000 first at 5.25%
$100,000 second at 8.5%
$50,000 consumer debt at 12%

This person then used standard practice to compute a weighted average cost of capital of 6.575, and justify refinancing all of it into a new first at 6.25%. They also assumed a tax bracket of 40%, which is a little higher than most folks pay, even with state tax figured in. Furthermore, it just took for granted the fact that there's enough equity in the property to absorb the full amount of excess debt without PMI. Robert Heinlein introduced me to this kind of attitude in Stranger in a Strange Land, calling it "straining at flies and swallowing camels," which is an apt description of what's going on. Theater.

What's really making the calculation work in favor of refinancing is that $50,000 at 12% without deductibility, and assuming a tax bracket higher than most people are in. Even the top federal bracket is 39.6%, so if you live in a state without income tax (quite a few), the article was overstating any possible current benefit. Furthermore, those states without income taxes tax mortgage loans on the basis of size, some of them pretty steeply. I just got an email from someone in one of those states back east, and for a mortgage under $250,000, the state was charging about $7000 in taxes. That's almost a 3% surcharge on the base mortgage, and if you're going to roll it into the balance, you're likely to be paying points up front. You're also paying interest on it basically forever.

Doing the calculation on the basis of pure interest rate calculation, like the manuals teach (I've got an accounting degree) ignores the costs of consumer loans. For corporate transactions, the costs are built into the the interest rate of the obligations. For consumers and residential real estate loans, this is not the case. You're going to be paying thousands of dollars for the privilege of refinancing - points and fees, and in many states, taxes. As I've made clear in the past, there is ALWAYS a Tradeoff between Rate and Cost in Real Estate Loans, and the standard WACC computations do not include cost of doing the loan in whether it's worthwhile, only the rate. This makes it seem like the rate with three or four points is necessarily better than the rate with none, when in reality it's likely to take eight to ten years before the lower rate pays for its cost in terms of interest savings. Most people will never keep a given real estate loan that long in their lives.

Now just for a moment, let's give the author of that article everything they're asking for. In order to be able to absorb this debt without PMI, the property has to be worth $625,000 minimum, plus 125% of whatever fees and prepaids get rolled into the balance.

What this means is that I could at that same time, without touching that 5.25% first, refinance that second into a 30/15 at around 7.25% (lower today), and still get paid half a point yield spread to do a very easy loan that costs the consumer less than $1000 all told. You see, not only do we get a price break for the bigger equity loan, but because it's only 80% Loan to Value Ratio (actually CLTV), and so we get a price break of

$350,000 at 5.25%, 40% aggregate tax bracket, 70% of the loan, =2.205% contribution from this
$150,000 at 7.25%, 40% aggregate tax bracket (on 2/3) 20% of loan = 0.870% contribution
$150,000 at 7.25% non deductible on 1/3 10% of amount =0.725%
2.205%+0.870%+0.725%=3.8% weighted average cost of capital, which essentially ties the projected 3.75% on 6.25% which is 40% deductible, but the lowered cost more than covers the difference in interest - $250 per year - for ten full years, just based upon the difference in closing costs, never mind points or cost of interest on the increased balance.

So why do loan officers push a full refinance when there are better options? Quite simply, they make a lot more on first mortgages than second, so it's in their best interest to make it seem like refinancing a first is in your best interest, even when it clearly is not. Second mortgages are something I'll do for existing clients, but it's not business I chase because I just can't make enough to make it worthwhile, and chances are that a credit union is going to do about as well as I can. First mortgages, however, are a different matter - and not just for me. The projected first mortgage would make me roughly 7 times what that second does, and my margins are low by comparison with the rest of the industry.

Because of facts like this, you need to know enough to think about alternatives like refinancing a second and leaving a low interest rate first untouched. This is also why you need to talk to more than one potential provider, to increase your chance of getting one of them to give you a better way of doing things.

Caveat Emptor

Original article here