One small investment, one BIG return

03.27.09
By Randy Johnson

In this article, I will show you how a $10 investment helped one couple save over $100,000. Read on...

In a recent article, I discussed a simple mathematical method for making better refinancing decisions. The important thing is to look at the savings generated by the difference in interest. Looking at the payment masks the real benefit because as the interest rate decreases, a greater proportion of the monthly payment goes to principal reduction.

We learned that a quick way to calculate the value of a transaction is to compare the cost and the benefit. This allows you to determine how quickly the savings in interest would allow you to recoup the initial outlay in upfront costs. For example, if you had an outlay of $4,000 and you save $1,000 per year in interest with a refinance, you would recoup your money in four years. That’s pretty good. Leaving $4,000 in the bank for 4 years might produce a whopping $160 in interest.

Of course, this calculation doesn’t answer all of the questions that might come up, so we might want to make more sophisticated calculations. In many cases this can be done with a spreadsheet program like Excel. Unfortunately, not all of the tools you need are built in the standard formulas. But there is another cheap tool that can help.

It’s the Texas Instruments BA-35 calculator. I found them on sale at eBay for under $10. In this article I’ll show you how you can parlay that investment into $50,000 or more on your loan by using the calculator to get more precise answers and make decision-making more efficient. Now, before you say, “No way,” let’s do the math.

Let’s back up just a minute and figure out how most people make calculations. Let’s say that you have a current balance of $300,000 on a mortgage that you got 5 years ago. The payment at 6% is $1932.90. You are considering a refinance because you were offered a loan at 5.25% with $9,000 in costs. The payment on that loan is $1656.611, a savings of $379.29 or $3315.47 per year.   

That sounds good, but there is a problem. Although the payment is lower after the refinance, you move back out to the lousy end of the amortization curve. You have to make 360 payments on this new loan, whereas you only owed 300 payments on the old one. Let’s use the calculator now. I’m not going to work through step-by-step calculations, but I will give you the results, and titillate you with power of this little device.

Under the old loan, you owe 300 payments over 25 years, paying a total (with principal plus interest) of $279,871.27. However, if you refinance, even though the monthly payment is lower, you owe 60 more payments and the total (with principal plus interest) goes up to $296,380.01. That’s $16,508 higher. Also, you paid out $9,000 in costs. You thought that you were saving money because the payment went down, but you ended up paying $25,000 more over the life of the loan. Doesn’t sound like much of a deal, does it?
 
Are there other (more favorable) alternatives? You bet! One answer is to keep the payment the same. If you do that, you convert the interest rate savings to reductions in principal, shortening the life of the loan from 25 years to 21.7 years, and the total (with interest) drops to $203,170. You now save $76,900 less that $9,000 in costs = $67,900. That looks better than paying $25,000 more, doesn’t it?

Being smart with your calculator saved you $67,000. THAT is why it is important to do the math.

I’m going to give you one more example from real life. A couple owed $561,000 at a rate of 5.75%. They had an opportunity to refinance into a new loan at 5% for a cost of $10,000. One borrower gagged at the $10,000 and said that she calculated that they would save almost as much if they just took the $10,000 they owed and sent it to the lender to reduce the principal balance. Therefore, she didn’t want to spend the money to refinance. Was she right?

	Original loan	Pay down principal	Get new loan
Principal	561,000	551,000	571,000
Rate	5.75%	5.75%	5%
Remaining Balance  (principal + interest)	497,786.11	466,882.60	380,690.79
Savings		30,903.52	117,095.32

You can see that whatever method she used, she was wildly off the mark. Perhaps she actually did the first calculation correctly. She saw that $30,903 and in her mind, it was enough. She underestimated and discarded the second calculation without even doing it on her calculator.

With the real numbers in front of this couple, they quickly went ahead with the transaction.

Texas Instruments has sold millions of these calculators and millions of people have learned how to do calculations just like this. I have great confidence that you can too.
 
So, one last question: Is saving $117,095 a good return on a $10 investment?

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A quick way to calculate the value of a transaction is to compare the cost and the benefit.