Mr. Friedman owns a house, which he purchased five years ago. He had financed the purchased with $450,000 mortgage with an interest rate of 9%, a 30 year term, and a 1.5% origination fee. Today, a new mortgage can be obtained at 6% for 25 years with a 1% origination fee and 2.5 discount points. If Mr. Friedman pays off the existing loan within 8 years of origination, a 3% prepayment penalty will be charged on the outstanding loan balance. He intends to sell the house five years from now. To finance the initial investment required to refinance the house Mr. Friedman can obtain a personal loan at 9% for 60 months, or he can use his own capital. A) Should he refinance if his opportunity cost of capital is 8% (in other words, if he didn’t use his money for refinancing, he could invest it at 8%)? Assume that the new loan amount would be equal to the outstanding balance of the loan.
B) Ignoring taxes, which source of funds should Mr. Friedman use if he decides to refinance the house? Explain.