Our society is a debt-based one, all but forcing us to rely on loans or lines of credit to get the things that everything else has and feel accepted, be it car or home loans, credit cards or schooling loans. Business and governments often operate under debt as well, making this anything but a personal financing issue. The real question is not so much will you get in debt at some point, but rather how can you avoid getting into too much debt. In this article we'll look namely at home mortgages and how they play into the whole concept of positive leverage.
Your mortgage is not just a monthly payment, it's a form of leverage to finance an asset for potential future gains. A mortgage is calculated as a liability on a home owner's balance sheet, reducing the remaining value owed from the household's net worth, which includes the full value of the house. Refinancing one's mortgage is a popular choice than lower the monthly payments owed, but this can negatively affect the total net worth of the household.
What refinancing does is reduce the monthly payments in exchange for an upfront fee. Logically this can make sense when a family is going to be living in the home for years to come. The equation of how long the person would have to stay in the home before the savings outweigh the cost is called the payback period. If the payback period is 20 months, then after that 20 month period, the savings to that point would have made up for the refinancing cost, with all future savings being a bonus.
Your net worth does suffer in this transaction though, for two reasons. The first is that the initial cost of refinancing is a liability that immediately lowers your net worth, with all other things remaining constant. The goal is obviously to make up for that initial liability over the longer term, but until that point your net worth is lowered.
Secondly, refinancing a mortgage into a longer term can actually increase your costs over the full length of the mortgage, or even them out at the very least, giving you no gains at all.
Now over the long term these concerns may not prove of much concern at all, but for the purposes of generating a true payback period in the event that you may not be staying in the home for the long haul, there is a much better approach that can be taken to calculating this, through the old and new mortgages amortization schedules.
Firstly the cost of refinancing is included in the amortization schedule of the new mortgage, and subtracted from the principal balance of the old one, under the theory that the money could instead have been used to pay down the principal of the existing loan. The difference in monthly payment savings should also be reduced from the new mortgage for the same reason as above, that it could be used to pay down the principal. Now you can get a true sense of the real payback period of refinancing.
What you'll find in most cases is that the real payback period is significantly longer than the payback period appears under the simpler method of calculation, 50% longer or more.
This approach takes a bit more work, but amortization calculators are available through many websites, and these can be used to help you with the calculations. By taking this approach, you can avoid seriously hurting your potential net worth and by refinancing under the wrong circumstances.
Background Harry was in the ready-mix concrete business. With lots of constructionand developments underway, concrete was a good business. Like hiscompetitors, Harry ran a busy yard lined with trucks loading sand,gravel and cement for construction sites. The Problem To customers, unfortunately, concrete was concrete -- anundifferentiated product called a commodity. Harry noticed the firstthing contractors asked on the phone was "What's your price on a yardof concrete today?" Then they called three or four other ready-mixplaces to find the lowest price that day. It was easy to be caught in a "race to the bottom": low prices,skimping on the mix of materials, paying the lowest wages, using poorlymaintained equipment, giving poor service -- and ultimately gettinglittle or no profit. The Solution Harry decided he didn't want to race to the bottom. He had to dosomething to rise above the pack. After we analyzed the problem, Iworked with Harry to develop a script. He began by asking contractorsquestions that showed his expertise about the applications of concrete. First he asked, "Before I tell you my price, tell me what you're goingto use it for?" If it was for footings or for sidewalks, curb andgutter or for wellhead seals, his next questions was, "Whatmunicipality are you pouring in?" Because he knew the zoningdifferences, Harry would remind them that the city and county haddifferent requirements." Harry even offering bidding advice, tellingcontractors, "When you get quotes from the other guys, remember to askfor 6 sacks of cement per yard as opposed to 5 sacks, or you'll wind upjack hammering it up and redoing it." Then he'd remind them aboutadditives for surface texture or hardening speed. He even alertedcontractors that some suppliers of concrete had a "standby charge" ifthe trucks had to wait to unload--which he did not. Immediately, contractors were listening closely to Harry's questions. By the use of scripts and questions that demonstrated his knowledge ofconstruction requirements, he was able to differentiate his offering.He was not just in the concrete business; he was also in the concreteapplications and the "I'll keep you out of trouble" business. The Result Harry became a valuable supplier because the last thing thatcontractors want is trouble from architects and building inspectors.They learned that Harry had the practical knowledge to keep them out oftrouble. And, he consistently got a higher price for his product. Theother suppliers fought the commodity price war. Over 15 years, Harrymade a good living from good contractors who understood that price isnot everything. Finally, having secured his retirement getting a good Harry sold the business. What happened then is very telling. The person who bought the businesshad a long history in the other end of the concrete business--concreteas a commodity." His answer to the question, "What's your price onconcrete today?" was "What's your best price and I'll beat it." In fouryears, the business was bankrupt. Commentary Every business has four components: product, knowledge, service ? andthen price. In my consulting with small businesses, I have found mostof them focus on price, maybe some aspect of product and service, butforget totally about their knowledge - their valuable "extra". Why?Because it is an intangible. But to customers, it is very important andthey are willing to pay for it. It can be the essential difference thatset you apart and makes you offering unique If you've been in business more than 10 years, you've forgotten howmuch you know - the stuff you learned the hard way. Most of yourcustomers don't have this knowledge. By presenting your knowledge in asystematic way, you differentiate yourself, provide added value to yourcustomers and justify a premium for your offering. Knowledge has value,too.
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Darren Cason has sinced written about articles on various topics from Check Credit Rating, Finances and College Student Loan. Darren Cason shares his vast knowledge at . To keep you better informed there is lots more on the topic of. Darren Cason's top article generates over 22200 views. to your Favourites.
Don has sinced written about articles on various topics from GPS Vehicle Tracking, Computers and The Internet and Multi Level Marketing. Author BioDon Morrison of The ProfitProcess consults small business owners on making a business more profitable, ,Valuation. Don's top article generates over 4400 views. to your Favourites.