The complicated transaction: Using net present value to weigh the costs and benefits of the cash-out refinance

Abstract

Cash-out refinance transactions present unique challenges for borrowers as they involves a myriad of moving financial variables, making it difficult to evaluate the costs and benefits of the loans. While many states have passed legislation to protect borrowers from loan flipping by “net tangible benefit” requirements, no standard financial analysis has been utilized to effectively weigh the costs and benefits of these transactions. In this paper, we explore the appropriate measurements for “net tangible benefit” using simulated cash-out refinances as well as a unique dataset of subprime loans containing information not typically accessible to researchers. Our findings illustrate the complexity and potential pitfalls of these transactions, and suggest that a formal cost-benefit analysis for cash-out refinances should be considered as part of the larger mortgage reform currently underway.

Keywords:

• mortgage
• prepayment
• debt
• predatory lending

Notes

¹Of course, such transactions can also have the effect of transforming unsecured debt into debt secured by a borrower's principal residence, removing potentially valuable options the borrower might otherwise have available through bankruptcy.

²RESPA disclosures including the GFE and HUD-1 settlement statement were revised as of January 1, 2010.

³To further confirm our argument, we generated NPV curves under varying discount rates for cash flows A and B. It does show that Flow A may have a higher NPV for certain discount rates than for Flow B, even though Flow A has a lower IRR than for Flow B.

⁴The hybrid adjustable rate mortgage product that dominated the subprime mortgages was essentially designed to require serial refinancing through the short period of the fixed rate followed by large rate adjustments upward.