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Cash-Out Refinancing: Check It Out Carefully

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Letter Writer:

Rolly Hughes, an investment manager in Midland, Texas

Date Posted:

Aug. 4 , 2005


I found this edition of The Regional Economist to be full of useful information, especially the article regarding the economic effects of smoking bans. One thing puzzles me, though. Maybe I don't understand mortgage financing, but the explanation of duration in this article seems to be backwards, and the terms of duration cited more appropriate to an investment in a mortgage rather than the paying of one.

According to a spreadsheet I made, the time it would take to pay off half the debt on an 8% 30 year mortgage is 270 months, or 22.5 years. At 6%, (it is) 253 months or 21 years 1 month. Also, once the mortgage is made, inflation expectations have nothing to do with the payment of the loan unless principal payments are increased with inflation to accelerate paydown. I would certainly appreciate an explanation of where I might have gone wrong.

Author's Note:

"Duration" is a mathematical measure of the weighted average time to maturity of a sequence of cash flows. Duration of a financial instrument, such as a mortgage, is the same for the borrower and the lender. You are correct that, in some applications (e.g., portfolio analysis or duration-gap analysis), it is appropriate to think of assigning opposite signs to instruments that are assets (positive) and liabilities (negative). The analysis of duration in this article refers only to the absolute value, not the perspective taken.

As for how long it takes to pay off half of the mortgage, the precise statement is that duration represents the time it takes to make payments that represent one half of the present value of all promised cash flows, viewed from the initial time period. This is different from paying off one half of the principal, which clearly takes much longer than the 10 or 11 years cited in the article.

Finally, changes in expected inflation after the mortgage is written may affect future growth of income, and not, as you correctly point out, the contractual mortgage payments (of the original mortgage). The key point in the article was that the economic burden of a mortgage depends on both the mortgage payments (which would not change) and future income (which could change). This often-forgotten interaction is why falling mortgage rates create a complex problem for analysis.