Cost/Benefit Analysis

Sometimes you have to wonder about how people make decisions. Mostly it's a matter of satisfying a "want." As in, "I want a new DVD player." "I want a new car." "I want to go to a bar and get drunk on Saturday night." "I want to buy a lottery ticket."

Whatever the choice, it may be one of the reasons why more than two-thirds of Americans do not have enough money to secure a comfortable retirement. It also makes you wonder about how they make some of the bigger decisions, those involving a lot more money. Having watched consumers for more than a generation now, I am convinced that many use the same process.

In business and in public agencies, the expenditure of money is accompanied by a lot of analysis to test the merits of the investment.Businesses typically use a discounted cash flow analysis to come up with a return-on-investment, or ROI, for each project. In a company I used to work for, they complied the list of proposed projects for the various operating units, ranked them according to ROI, and starting at the top, approved projects down the line until they had exhausted that quarter's capital budget.

Public agencies typically use a cost/benefit analysis. In this procedure you calculate the anticipated benefits of a project and compare it with the cost, approving those projects where the benefits are significantly larger than the cost. Not only does this methodology help invest public funds wisely, it gets people out of the trap that many so easily fall into, looking only at the cost.

If someone is unsure of the benefits of a project, it is really easy to say, "It costs too much." Indeed, there are lots of people in this country who say that about all kinds of government programs. They may be right, who knows, but at least such programs went through some rigid scrutiny somewhere in the funding process. If they wanted to have an input, that is where it should have been made, not just complaining about it later.

One reason I like the cost/benefit method when working with people contemplating a refinance is that it gets them off of the, "It costs too much," syndrome. I worked with one couple whose refinance would have cost about $5,000, but saved them more than $60,000. They were social acquaintances so I did not really force the analysis issue, thinking that they needed some time together to discuss it. They didn't call back, and when I called them, their response was, "Your costs are too high!"

Had I known they really were going to be turned off by spending any money at all, I could easily have proposed a no-cost refinance which would have saved them about $45,000. Now you can quickly see that it would have been better for them to spend an additional $5,000 up front and save an additional $15,000, but that wasn't the way they were looking at it. How stupid, you might think, to pass up the savings whether it was $45,000 or $60,000. Indeed!

I talked with another couple recently who were contemplating refinancing their 7/1 ARM into a new loan. Because they were at 5.625 percent already, the only thing that made sense was another interim ARM. We had one lender with a terrific loan, at 3.5 percent for five years, but it involved paying points up front. I couldn't get the exact pricing when they were in the office, but I promised to check it out, do the analysis, and get back to them.

When I did the analysis, subtracting the cost from the savings demonstrated net benefit of $28,000. That was pretty good, and it was a guaranteed return. But one of the parties just wanted to know, "What is it going to cost?" I wouldn't tell her because I knew the moment I said anything, her response was going to be, "It's too expensive." I knew that to succeed, I needed to sit down with her and go through the benfits and at that point, she wasn't concerned in the slightest about the benefit, as you, dear reader, would have been.

Now it may have been that she was one of those people who have a tough time making a decision. I am quite sympathetic with that because it can be mystifying to people. Yet I pride myself on helping such people go through a rational analytical cost/benefit analysis to arrive at a decision they can understand and be comfortable with. As a result I have helped people save, literally, tens of millions of dollars when they might not have been prepared to move ahead without such analysis. But they have to listen.

I think you ought to use this method because you will find it easy to understand. If you are looking at a potential refinance, ask your mortgage professional to work with you to show you the benefits of alternatives, and only then look at the costs.