The Economics Of Refinancing

Refinancing refers to the process of paying an existing mortgage with a new one.

While the majority of homeowners refinance their home loans to save on interest costs, a lot of them also do it to raise cash for various purposes.

Refinancing for savings

It goes without saying that in order to save money from the future payments towards a mortgage, the new mortgage has to have an interest rate lower than the existing one.

However, there are certain exceptions.

For example, even though a new loan might come with higher interest rates, it might have a significant reduction in the term. So even though bigger installments are made monthly, the early settlement of the facility will result in more savings in interest costs.

Borrower often go this route when they are unable to find home loans with cheaper or similar rates. But with a motivation to save money on interest, and a high income, they are willing to sign up for a loan with higher interest but a shorter term.

Yet most of the time, there almost always will be better deals on the market, barring extraordinary circumstances.

A solution that might tick all the boxes is a biweekly mortgage which received a lot of fanfare in recent years.

Costs and gains

In order to make an informed decision regarding refinancing, one must measure the costs and gains from switching to a new loan compared to the existing one.

A critical factor in measuring this is the time period which you intend to keep the new mortgage.

Only with this information will one be able to specifically calculate the total costs, and as a results the total savings (if any) compared with keeping the existing.

By plotting the amortization of the new loan, you should be able to pinpoint a specific period in time where the breakeven point is achieved.

The breakeven point being the point when the costs of the current mortgage equals to the costs of the new mortgage.

The longer you hold onto the loan past this breakeven point, the more savings you will theoretically make.

A common practice in the lending industry is to calculate breakeven points by diving the costs to refinance with the decrease in monthly payments.

For example, should the costs be $5,000 and the monthly payment reduction is $250, the breakeven point would be 20 months ($5,000/250).

However this is a poor way to calculate it.

This simple method does not take into account changes in:

  • Interest rates
  • Monthly payment amounts
  • Tax savings
  • Term
  • etc

This is why a more meticulous approach is needed to make a sound decision.

Moreover financing upfront costs are usually charged by lenders to refinancers, and not taken into account.

Unlike points that are deducted from disbursement, these are settlement costs that are added to the loan amount. Accumulating to a larger loan amount.

For example, a loan of $100,000 might have a upfront cost of $5,000. While the borrower does not need to fork out $4,000 in cash to pay settlement costs, this $5,000 is added to the $100,000 making the total loan $105,000.

This would probably be fine if a portion of installments based on a $100,000 principal goes towards paying for that $5,000. But what actually happens is that the interest costs charged by the lender will now be based on a principal of $105,000.

If a mortgage rate is 5%, 5% on $5,000 might seem an insignificant amount. But it can mutate into a monster when we account for the number of years the interest will be charged on.

This reduces the gains a borrower would make on refinancing.

It’s no surprise to find home buyers eventually repaying the lender twice the price which they initially bought their homes.

Another point to note is that should a borrower be taking 80% loan to value (LTV), adding the financing costs will tip LTV over the edge, making private mortgage insurance essential.

To address these concerns, some lenders do offer no-closing-cost loans in exchange for a higher interest rate.

While this can look attractive on the surface, be mindful that interest rates will kill you over the long term no matter how insignificant the increase seems to be.

If a no closing cost loan be your best option among the worst, then keep in mind that because of the premium rates, it is usually not worthwhile to keep the new mortgage for generally more than 5 years.

Anything more than that would mean that you will be adding more interest costs to your loan than you initially started.

So it can be a favorable proposition if one intends to sell the house within that time period. Otherwise, it MUST be refinanced to make financial sense.

Don’t make the mistake of confusing better rates with best rates.

Refinancing two mortgage

The task of refinancing becomes more complicated when there are 2 mortgages, and in effect, 2 liens placed by lenders on the house.

By right, when a property with 2 mortgages is refinanced, both the first and second mortgage has to be refinanced simultaneously.

But if you are a skilled sweet talker, you might be able to get either party to subordinate their liens or agree to your evil plans.

In theory, you can either:

  • Refinance both into one new mortgage
  • Refinance both into two new mortgages
  • Refinance the first without the second
  • Refinance the second without the first

Bu tin practice, it is very tough to get lenders to agree on compromising their positions. So the most likely outcome will still be that you have to refinance both.

What about loan modifications?

A loan modification basically refers to renegotiating the terms and conditions of a loan. Usually because the borrower is being squeeze financially and struggling to meet payment deadlines and obligations.

In some places, this is also known as re-pricing.

This is surprisingly easy to do.

I’ve received many calls from homeowners asking about how they can get their banks to reduce their interest rates.

The simple answer is: Give them a call

Calling them would generate one of two results

  1. They say “Okay, let’s go!”
  2. They hang up the phone before you even give them the property address

I have witnessed even the most unlikeliest of borrower get an immediate offer from the lender to modify the loan. And also those with above average credit get turned down in a whimper.

The thing is, we will never know what’s exactly going on behind the scenes of a bank. They have a variety of reasons to do certain things.

It could be that they have gotten wind of a fierce competitor running a killer deal promotion next week that will potentially entice a bulk of their customer to switch. It could be that a loan officer has certain targets to hit and you are the lucky caller. Or that maybe top management has identified certain flaws in their mortgage contracts signed off during a certain period in history, and giving affected borrowers a new contract is the best way to amend the terms discreetly.

It could be anything. Just call.

If you need to present a strong case for loan modification, then it would aide your case if you prepare:

  • Personal financial records showing cash flow bottlenecks
  • Market data reports showing how valuable your house is worth
  • Records of bad tenants who are presenting collection problems
  • Unique events that are tying up your cash

What you need to remember when presenting a case for loan modification to the lender is that you are not exactly poor, and that your current financial status is more of a cash flow problem.

If the lender is the servicing agent who owns the loan, then it has the absolute power to make contract modifications.

However if they are just servicing agents of another owner, then your chances drop ten-fold.

Refinancing to raise cash

There are so many words used to describe raising cash from home equity.

But other than a straight term loan from an unencumbered property, almost every other variant of home equity loans fall into the category of refinancing to raise cash.

A loan against an unemcumbered property can be considered as a cash out with no refinance.

A cash out refinance for example, is the act of refinancing an existing mortgage with a new and bigger one.

Whether the new loan will be a better one depends on various factors.

But when the goal of borrowers is to raise funds, they are usually willing to compromise on terms and interest rates.

The reasoning with higher interest rates

For lenders, “higher risks, higher returns” is a prerogative that is practiced religiously.

It’s after all, one of the best excuses for rate hikes that can be easily disguised as justification.

The statistics say, and I have never seen these research reports, that borrowers who cash out have a higher tendency to be delinquent and default compared to those who don’t cash out.

I personally can’t see the sense in that as it is like comparing a person who ate dinner and one who did not, about who is more likely to have had a burger and fries.

Moreover, almost all the people who cash out had once been a non-cash-out borrower.

Anyway, the “studies” have shown that there is a higher risk to lend to cash out borrower.

That is the justification for higher interest rates.

Cash out or second mortgage?

In view of interest rates and the costs of settlement, borrowers who need to raise cash from home equity should compare the costs of a cash out refi and a home equity loan via a second mortgage.

Critical factors to evaluate include:

  • Loan amount
  • Property appraisal value
  • Loan to value
  • Tax bracket
  • Interest rates
  • Points
  • Penalty fees
  • etc

As the decision ultimately comes down to costs, a detailed breakdown of costs will be essential in making an informed decision.