A Closed-Form, After-Tax, Net Present Value Solution to the Mortgage Refinancing Decision

Abstract

Refinancing one's mortgage is often an attractive, wealth-enhancing option for homeowners in a declining mortgage rate environment. In some respects the decision is simple to analyze because future cash flows are relatively easy to define for fixed-rate mortgages. In other respects, however, the decision is nuanced by option pricing and tax considerations. The analysis must first begin with accurate after-tax, net present value solutions for varying potential holding periods. This study improves upon previous studies, which either ignore tax implications or address them iteratively in spreadsheet model solutions, by introducing a closed-form model that incorporates the ever-changing tax shield of the interest portion of each mortgage payment. Further, unlike many previous studies, our model does not assume that the current and replacement mortgages have equal remaining terms.

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Notes on contributors

Richard A. Followill

Richard A. Followill is a professor of finance in the Department of Finance at the University of Northern Iowa. His interests include derivatives, real estate, inventory models, and market efficiency. Dr. Followill received his Ph.D. in finance and his B.S. in industrial engineering at the University of Alabama.

Brett C. Olsen

Brett C. Olsen is an assistant professor of finance in the Department of Finance at the University of Northern Iowa. His research interests include corporate governance, ownership structure, and real estate. Dr. Olsen received his Ph.D. in finance from the University of Missouri and his B.S. in mechanical engineering from North Dakota State University.