Borrowers refinance for three reasons: to raise cash, to reduce monthly payments,
or to lower interest costs.
Refinancing at a higher interest rate to raise cash, or to lower monthly payments,
may be justified but often isn’t, for reasons explained below. Refinancing at
a higher interest rate to lower interest costs is never justified, although
there are some snake oil salesmen in the market who would like to convince you
otherwise. I’ll explain their tricks further below.
Raising Cash: Refinancing to raise cash means that you borrow more than
the balance of the old mortgage. This is called a "cash-out refinance".
Very often, the rate on a cash-out refinance is higher than the rate on the
mortgage that is being paid off.
I can’t say that this is never a sensible thing to do. If a family member is
critically ill, and if a cash-out refinance is the only source of cash for a
life-saving operation, then you do it. Yet the number of rate-increasing cash-out
refinances that can be justified by dire circumstances is very small. In all
too many cases, the borrower had a better option but didn’t realize it.
For example, Betty had a $210,000 mortgage at 7% and needed $18,000. She took
a cash-out refinance for $232,000 at 7.5%, which covered the $18,000 she needed
and $4,000 of settlement costs. She could have obtained a second mortgage for
$18,000 but decided against it because the rate was 10.5%. That was a mistake.
What Betty overlooked was that if she took the second mortgage, she would be
paying 10.5% on only $18,000, while retaining the $210,000 loan at 7%. With
the cash-out refinance, in contrast, the rate on $210,000 was raised by .5%.
Paying 7.5% on $232,000 costs more than paying 7% on $210,000 and 10.5% on $18,000.
Unfortunately, the Truth in Lending (TIL) disclosures provided to Betty encouraged
her to make this mistake. They indicated an Annual Percentage Rate (APR) of
7.60% on the cash-out refinance, and 10.90% on the second mortgage. Illogically,
the APR on her cash-out refinance did not take into account the cost of raising
the rate on $210,000 by .5%.
An APR on a cash-out refinance that is comparable to an APR on a second mortgage
would be based on the net cash raised, not on the total loan amount. This "net-cash"
APR was 14.82%, which was well above the 10.90% APR on the second. If the net-cash
APR had been provided to Betty, she might well have avoided the mistake.
The Federal Reserve administers TIL but don’t expect it to fix this anytime
soon. Meanwhile, you can compare the cost of a cash-out refinance and a second
mortgage using calculator 3d.
Reducing Monthly Payments: While refinancing at a higher rate to lower
monthly payments is nowhere near as common as refinancing to get cash, it happens
occasionally. The payment can be reduced only if the remaining term on the existing
mortgage is short. This allows a lengthening of the term to reduce the payment
by more than the higher rate increases it.
Charles took out a 15-year mortgage in early 1994 at 6.5%, and has paid down
the balance to $200,000. But Charles’ income has unexpectedly dropped and he
can no longer afford the mortgage payment of $2,970. He plans to refinance into
a 30-year loan at 7% on which the payment is only $1,331, but at a cost of $3,500.
At my suggestion, Charles asked his servicing agent whether it would be possible
to extend the term of his existing loan, or reduce the payment to interest-only
for 5 years. In cases where a servicing agent also owns the loan, the agent
may be willing to do this for a small fee to accommodate a customer. However,
the answer to Charles was "no", because the agent did not own the
loan and had no discretion to adjust the terms.
In fact, the loan was in a pool of similar loans against which a mortgage-backed
security had been issued and sold to multiple investors. Changing the terms
of loans in pools against which securities have been issued is forbidden. While
the "securitization" of mortgages has driven down interest rates by
increasing the efficiency of the system, it has eliminated the flexibility to
negotiate changes in the contract. Charles was forced to pay the $3500 in refinance
fees.
Reducing Interest Costs: If the purpose is to reduce your interest costs,
it never makes sense to refinance at a higher interest rate.
To an economist, this is self-evident, but it isn’t to many readers, which
is why I keep returning to the topic. Hardly a week goes by that I don’t hear
from confused homeowners who are being badgered by snake oil salesmen (SOS)
trying to convince them that their higher rates actually cost less.
These SOS believe their own spiel. In fact, several of them have pitched it
to me, in the expectation that once I understood it, I was bound to endorse
it. Well, I do understand it, and it is a scam. Here is a typical conversation
between an SOS and me.
"SOS: Will you agree that the important thing is not the interest rate
but the total amount you actually pay in interest over the life of the loan?
[Note: this is the key point of the spiel. If the SOS gets you to agree to this,
you are well on your way to being conned.]
JG: No. The amount I pay in interest over the life of the loan has to be
related to the amount I borrow. If you reduce my interest payments by reducing
the amount I borrow while raising the price, you are doing me no favor.
Let me make you a similar offer. Right now, you can buy 10 lbs of sugar
at $1 a pound, spending a total of $10. If you will agree that the most important
thing is the total amount spent on sugar, I will sell you 5 lbs for $1.50 a
pound, or $7.50 in all. This will save you $2.50.
No one would be fooled by the sugar case, of course, yet many people buy into
the same argument in connection with their mortgage. Their confusion arises
from the fact that the "amount" you borrow has two dimensions: the
loan size, and the amount of time it is outstanding, which depends on how fast
you repay it. The SOS exploits this confusion with examples such as the following:
SOS: Your present 6.60% mortgage has a balance of $200,000 and 300 months
remaining to term. Over that period you will pay $208,881 in interest. If you
refinance into our mortgage at 8%, you will pay $200,986 in interest, or $7,895
less.
JG: True, but you have reduced the amount I am borrowing, which is like
selling me a smaller bag of sugar at a higher price. Your mortgage is a biweekly
that requires me to make an extra payment every year. I don’t need to raise
my interest rate to make an extra payment. I can convert my current loan to
a biweekly for a setup fee of $200 or $300. This would reduce my total interest
payments to $169,614, which is $31,372 less than I would pay with your 8% mortgage.
Indeed, I can do even better by increasing my regular monthly payment by 1/12.
This is the equivalent of one extra payment a year, the same as with a biweekly,
but the savings begin with the first additional payment. Total interest payments
in this case will be $167,849, or $1765 less than with the biweekly, and there
is no setup fee.
SOS: Our biweekly is unlike any other and generates far more savings for
the borrower.
JG: The biweekly you offer is only slightly better than the standard biweekly,
and the difference is far outweighed by your higher interest rate.
The SOS make exaggerated claims for what they call a "simple interest
biweekly". It benefits the borrower by reducing the loan balance on the
day a payment is received. The benefit, however, is very small.
In the $200,000 mortgage at 6.60% referred to above, interest payments on a
simple interest biweekly are $167, 306. This is only $543 less than when the
monthly payment is increased by 1/12. You only have to raise the interest rate
from 6.60% to 6.63% to eliminate the benefit. And if you raise the rate to 8%,
which is actually on the low side of the deals promoted by the SOS, it is a
loser big time.
Note: All the numbers cited above were drawn from a biweekly spreadsheet that
is now available by clicking on Spreadsheets.
April 8, 2002
