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The Monthly Payment Economy


The US economy is based on monthly payments. Today's consumers focus on what the monthly payment is and not the total price paid. While there is not any hard data to confirm this, there is ample amount of anecdotal evidence. Of course with interest rates on consumer borrowing at historic lows, there is some justification to financing purchases instead of using money on in the bank, especially when rates are zero percent in the case of new car loans. However, Americans have very little in savings, and the ability to finance every purchase causes consumers to have a very high fixed budget. While there is little concern for stretched budgets during a booming economy, this financial leverage poses significant stress when the economy weakens.

This is hardly a new development, but it recently hit home when I looked into joining the masses and refinance my mortgage. Being an analyst, I had to run the numbers myself and the results were surprising. Currently I have a 30-year mortgage at 7.125% that is almost five-years old. In order to determine if refinancing was attractive, I compared what the total amount paid would be and compared it to how much more I would end up paying if I just used what would be the closing costs, approximately $4,000 and made a lump sum prepayment of my existing mortgage. Even though the monthly payment dropped, the total amount paid was actually higher by a few hundred dollars if I refinanced. That is sure not what I expected after hearing the experts pushing refinancing on everyone.

I decided to find out just how advantageous refinancing was since I didn't find the Holy Grail.

The assumptions used are:
Original mortgage amount: $125,000
Term: 30-years @ 7.125%

Refinance rate for 30-year mortgage is 6.0%. Closing cost equal $2,500 plus 1% of the principle balance of the existing mortgage.

Base case is fully paying the existing mortgage without any prepayments.
Interest Paid: $178, 173
Total Payments: $303, 173

The first scenario is refinancing at 30-years at a lower rate and rolling the closing costs into the mortgage balance.

  Years in Original Mortgage
  1 2 3 4 5 6
Principle left 123,761 122,430 121,001 119,467 117,820 116,052
Interest paid 8,866 17,641 26,318 34,890 43,349 51,687
Closing cost 3,738 3,724 3,710 3,695 3,678 3,661
New Loan amount 127,498 126,154 124,711 123,162 121,499 119,713
Interest on new loan 147,691 146,135 144,463 142,669 140,742 138,673
Total interest paid 156,558 163,776 170,781 177,559 184,091 190,360
Principle paid 128,738 128,724 128,710 128,695 128,678 128,661
Total 285,295 292,500 299,491 306,254 312,770 319,021
Savings 17,878 10,673 3,682 (3,080) (9,596) (15,847)

Refinancing is only advantageous if done within the first three years, and only significant if done during the first two years. The situation improves if closing costs are paid up front instead of rolling the costs into the loan.

  Years in Original Mortgage
  1 2 3 4 5 6
New loan amount 123,761 122,430 121,001 119,467 117,820 116,052
Interest paid 143,363 141,821 140,165 138,388 136,481 134,433
Interest already paid 8,866 17,641 26,318 34,890 43,349 51,687
Total interest paid 152,229 159,462 166,484 173,279 179,830 186,119
Principle paid 125,000 125,000 125,000 125,000 125,000 125,000
Closing cost 3,738 3,724 3,710 3,695 3,678 3,661
Total 280,966 288,186 295,194 301,973 308,508 314,780
Savings 22,207 14,987 7,980 1,200 (5,335) (11,607)

By paying the closing cost up front, significant additional savings are realized, but only during the first three years. The fourth year still offers some savings, but not by a very significant amount. Some of the more astute readers will ask about the opportunity cost of the closing costs, and that is what makes this exercise interesting. Below, I calculated what the total payment would be over the term of the loan if instead of using the funds to pay for the refinancing, they were used to pay down the principle on the existing mortgage.

  Years in Original Mortgage
  1 2 3 4 5 6
Closing Cost 3,738 3,724 3,710 3,695 3,678 3,661
Interest Paid 155,171 156,925 158,571 160,120 161,580 162,947
Principle 125,000 125,000 125,000 125,000 125,000 125,000
Total Paid 283,909 285,649 287,281 288,815 290,258 291,608
Total Savings 19,265 17,524 15,892 14,359 12,915 11,566

Not only is it better to pre-pay the mortgage rather than refinance anytime after the second year, but its better than investing the amount at 5% (see below).

  29 Years 28 Years 27 Years 26 Years 25 Years 24 Years
Amount closing cost earned @ 5% 12,150 11,300 10,561 9,826 9,126 8,464

I have not discussed the tax issue, since it depends on itemization. Plus, as the interest paid declines throughout the term of the mortgage the amount of interest paid will fall below the standard deduction. This will negate the tax benefit mortgage interest tax-deductibility at some point during the life of the mortgage.

I was expecting much greater savings after hearing all the proponents pitching refinancing over the past several years. And was very surprised that after five years the total amount paid was higher by refinancing. In fact, prepaying the closing cost amount yielded better results than either refinancing situation after the second year. The fact that refinancing is so popular shows the extent that the economy is tied to monthly payments that are stretched to the brink.

The other big stimulus over the past year has been in selling cars. The heavy promotional activity is having a detrimental effect on the future of the industry. Buyers are purchasing cars now instead of waiting until next year. The issue is not confined to zero-percent financing. Auto buyers have been extending the length of the loan. The average term length on auto loans has steadily increased over time. During the early 1970s it was near 35 months and moved to the low 40-month range in late 70s. During the 1980s, the average length moved around from 50-months to 55-months where it continued during the 1990s. In 2000, the average loan length moved to over 57-months and jumped to over 58-months during the second half of last year. This has happened as new cars and trucks are the cheapest ever based on number of weeks required to work to buy the average car or truck. Last year, it only took 23.2 weeks to buy a car. In 1997 it was at 26.2 weeks.

Last month, the Dallas Morning News carried a story discussing the popularity of six-year car loans. In the Dallas area, 21% of new car and truck loans are six-year loans, with some banks are offering 7-year loans on vehicles costing more than $30,000. The article interviewed several dealership owners and without exception, they lamented that buyers are too focused on the monthly payment and are taking out loans as long as possible to lower the payment. One mentioned the buyers walk in and tell them what car they want and how much they want the monthly payment to be. "It's all about monthly payments now," said Mark Eddins, president of Friendly Chevrolet of Dallas. "This is a monthly pay market, and customers have been lulled into always expecting a low payment."

Dealerships have a problem that they need a much short cycle than six years to be profitable. The other problem with longer loan terms is buyers are "upside-down" for a substantial part of the loan - meaning they owe more than the car is worth. It's a bad business practice," said Sam Pack, owner of Sam Pack's Five Star Ford of Carrollton, "I cannot live with a seven-year trade cycle." Another dealer commented that he has seen the number of buyers upside-down on their existing car double in the past four months to 75%. The auto manufactures are creating quite a small box for themselves by pushing cars on consumers. The cash rebate incentives are aimed at buyers that are upside-down in their existing vehicle.

Another anecdotal bit of evidence showing how widespread the monthly payment mindset is came in the mail last week. A brochure from Carnival Cruise Lines advertised their cruises out of Galveston. Opposite the page with the prices for the four and five-day cruises, a box with big bold print displayed, $18 per month for a 4-day cruise and $19 per month for a 5-day cruise.

It seems there are quite a few financial professionals that have not read the details of the economic stimulus package. There continues to be commentary discussing what dividend paying stocks will benefit, or what companies will start paying a dividend. Richard Bernstein, chief US strategist for Merrill Lynch, noted that the tax relief given to the "reinvested dividends" that companies maintain, but can be used to reduce capital gains tax gives companies a disincentive to pay a dividend. "If companies can maintain control of the cash flow, and still offer investors a tax benefit, why would they offer dividends?," Bernstein said in a research note this week.

By the way, I'm leaning toward to refinancing to a 15-year mortgage.

Selected emails will be addressed in Bear's Chat.

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