Net Present Value: Why You Should Use it in Everyday Life

I was working on a Refinance this week and was confronted with various options: Different rate/point combinations, different lender fees, etc., and this got me thinking – I should just build a Net Present Value model to see which loan offered me the “best deal”.  Without objectively assessing all the cash flows in and out, “best” is subjective.  However, if you consider what the “present value” is of each offer and apply consistent criteria to each option, you can objectively assess the optimal solution.  Therefore, I constructed a Net Present Value (NPV) model for my various options at hand.  Present Value is simply the series of cash flows over time in terms of present dollars.  It factors in inflation and what you could make investing your money elsewhere.

Demonstration

The following 3 options exist for a conventional 30 year mortgage refinance:

1. 5.25% rate, zero points, $4500 in closing fees at Lender 1.
2. 4.75% rate, 1 point, $4500 in closing fees at Lender 1.
3. 4.875% rate, zero points, $2900 in closing fees at Lender 2

Can you look at these 3 options and clearly determine which is the “Best Deal”?

*Ignore the escrow for taxes and insurance since you should end up paying in roughly what you’ll get back from your existing lender at closing. Assumes a point costs $3000 due to a $300,000 mortgage.

How to Construct your own NPV model

1. The first thing you need to do is determine what your discount rate is.  The discount rate is the return that could be earned on an investment in the financial markets with similar risk.  Whereas business use a much higher number like say, 12%, individuals should use a much lower number which reflects the true expected return on what they’d be doing with the money otherwise.  In my case, I’m using 4.5%, since it’s roughly the return you can get on intermediate term CDs and Money Markets over the long haul.  I realize rates have dropped dropped dramatically in the past few months, but as recently as last year and for the several preceding years, you could easily earn 4-5% in such investments.  In a past life, I would have considered using 8% matching something closer to the long run return in stocks, but I no longer consider that to be a consistent assumption.
2. Next, you need to consider your time horizon.  I’m going to construct my model as a series of years, but you can use months, days, whatever you want, as long as you set the discount rate to match the same time period (i.e. if you were using months, a 12% annual discount rate would be entered as 1%).  I’m going to look a 10 year year example.  It’s a 30 year conventional mortgage, but a 10 year horizon is usually plenty of time to assess a situation.  Heck, I might move within 10 years or CD rates may skyrocket to 7% and the discount rate I had used is no longer relevant.
3. Finally, you must consider your cash flows.  In our case, there will be an upfront cash flow out for the points and closing fees.  Subsequent years will be considered cash inflows due to the decreased mortgage payments.  I simply subtracted the savings each month for the lower rate, annualized it and plugged in an annual savings number as my annual inflow.  I realize it’s a bit more complicated, like consider the tax impact of interest mortgage deduction and the change in interest/principal amortization over time, but for the example I’m presenting here, I’ve simplified it a bit.  I didn’t share my specific model since I’m switching from an ARM to a conventional and I had to include several other factors which really would have complicated the explanation.
4. The NPV Function in Excel requires you to input the discount rate first, followed by the annual cash flows (positive or negative).  You can hold <CTRL> and drag the mouse to capture all the values.  I’ve displayed the formulas in blue in snapshot below if you want to try to recreate your own file.

Now for the Formulas and Results:

Option #3 Wins Out!

Explanation:

In “Present Dollars”, it turns out that option 3 has the highest value to the decision maker.  While it may sound tough to believe, by making a decision today with a few hours of paperwork and some upfront investment, your present value increases by over $13,000 over the next 10 years; more than double that over 30.  This is no different than someone putting $13,000 in your pocket today.  If it is different, than your assumptions were incorrect.  Other than not having $13,000 to spend immediately, these discounted cash flows coming back to you via lower mortgage payments are worth that much.  It’s that simple!

Additional Uses of NPV in your own Personal Finances

NPV can be used for myriad situations you’ll face in life.  Check this out – the day you buy a new puppy, you may have just set yourself back $70,000 in present day value!!! – Dog Cost Analysis. I used a similar method when I bought a tractor for mowing the lawn.  I figured in what I’d be spending per year for a lawn service vs. buying a tractor and paying for gas.  While I didn’t factor in what my time was worth and frankly, I would never pay someone else to mow my lawn anyway, it was still a neat exercise to show that my 10 year savings would be something around $6800, which discounted back, would still be several thousand dollars in NPV.  NPV is really most useful in decided between various options as I highlighted in the Refi example.

You should consider getting some quick quotes from reputable lenders quickly and effortlessly from outfits such as Quicken Loans.

UPDATE 4/29/09: I actually ended up getting an incredible Refi deal.  Get this:

– 4.625%

-30 year conventional

–no points

–reasonable fees (actually, the lowest fees of all the options I considered as well).

Upon comparing with several other options (including my existing originator which was horrendous) and using my NPV model, none of them held a flame to what I was able to achieve with the mortgage consultant I worked with.  Since I’m pleased with all aspects from the communication to the accuracy of the good faith effort to the expediency of closing the deal in less than a month, I can honestly say that I endorse Jeff Harris for anyone considering a refi.  We live in different states and did everything remotely and efficiently, so anyone considering a refi should at least put him on your list of top options to evaluate; worked out great for me!

1-800-962-4145  or visit Jeff’s Webpage

Do you have any similar examples of decisions you need to make where NPV would be valuable?

Tagged as: Mortgage Rates, NPV, Refinance