Refinance or not?

Oct 9, 2022

Learning Goal: I’m working on a finance discussion question and need an explanation and answer to help me learn.
1. Refinance or not?
Click the link to watch the video:
Now that you have watched the video on making refinancing decisions, you are ready to help the Johnson family figure out whether or not it makes sense for them to refinance for a lower rate.
Jack and Amy Johnson live in a three-bedroom home with their children, Kate and Alex. They bought their home three years ago with a $200,000, 30-year, fixed-rate mortgage at a 3.5 percent interest rate. They have made 36 monthly payments, and they are interested in refinancing for a lower rate, the Johnsons checked their current lender for the refinancing rate and terms being offered to them. The loan offered was a 2.8 percent interest rate for another 30-year fixed-rate loan. The closing cost for new loan is $2000.
a. If refinance, will the Johnsons save on interest expenses over the total life of the loan at 2.8% and if so how much do they save?
b. At what breakeven refinance rate does the interest savings cover the $2000 refinance fee exactly? That means any rate less than the breakeven rate will provide net interest savings for the Johnsons. (Please show the calculation detail. Attach an Excel file if not able to type in the thread directly).
2. Nominal Rate vs. Real Rate
The U.S. Treasury issues some bonds as Treasury Inflation-Indexed Securities, or TIIS, which are bonds adjusted for inflation; hence the yields can be roughly interpreted as real interest rates. Go to the St. Louis Federal Reserve FRED database and find data on the following TIIS bonds and their nominal counterparts. Then answer the questions below.
5 year U.S. treasury (DGS5) and 5-year TIIS (DFII5)
7 year U.S. treasury (DGS7) and 7-year TIIS (DFII7)
10 year U.S. treasury (DGS10) and 10-year TIIS (DFII10)
20 year U.S. treasury (DGS20) and 20-year TIIS (DFII20)
30 year U.S. treasury (DGS30) and 30-year TIIS (DFII30)
a . Using the most recent data available, is the 5, 7, 10, and even the 20-year, 30-year TIIS yields (real interest rates)positive or negative? What does a negative real interest rate mean?
b. Using the most recent data available, calculate the difference between the yields for each of the pairs of bonds (DGS5 – DFII5, etc.) listed above. Please remember to show the calculation details. What does this difference represent? ((Hint: according to Fisher Equation, expected rate of inflation = nominal interest rate (DGS) – real interest rate (DFII), that is, π e = i – r, )
c. Based on your answer to part (b), which shows the magnitude of the variation in differences among the pairs, what do you think about the trend of the inflation expectation, the inflation will grow at the largest magnitude in 5 years, 7 years,…. 30 years?
3. Week 3 Reflection
Based upon what you learned in Week 3 study, share with your classmates something that you found to be an”ah-ha” learning moment and how it applies to your current or past experiences.

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