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18 April 2005
"I understand that in pending Federal
legislation aimed at predatory lending, lenders will be prohibited from
refinancing a mortgage unless there is a �tangible net benefit� to the
borrower�Is this a good rule?"
It is not a good rule, because it would make
lenders responsible for something over which they have little or no control.
All or virtually all refinanced mortgages
provide tangible benefits, otherwise borrowers wouldn�t do them. A borrower who
closes a refinance only to find that there is no benefit, has 3 days to rescind.
Even predatory lenders, who are the focus of the proposed legislation, provide a
benefit to the refinancing borrower.
The problem is that in exchange for the
benefit, the predator extracts a pound of flesh. That�s why the proposed
legislation requires a "net" benefit, meaning that the benefit outweighs the
cost. Unfortunately, there is no way that a lender can determine this. Whether
or not the benefit outweighs the cost in any particular case depends heavily on
what is in the borrower�s head.
This will become clear from looking at the
four main reasons that borrowers refinance: to reduce costs, raise cash, reduce
monthly payments, and reduce interest rate risk.
The Net Tangible
Benefit in a Cost-Reduction Refinance
A cost-reduction refinance is one in which
the new interest rate or mortgage insurance premium is lower than the existing
one. In most cases, however, the borrower incurs costs upfront. If there is to
be a "net benefit", therefore, the future savings must outweigh the
upfront costs.
But future savings depend, among other
things, on how long the borrower expects to have the mortgage. This critical
piece of information, if it is anywhere, is in the borrower�s head.
The Net Tangible
Benefit in a Cash-Out Refinance
Some of the worst market abuses arise on
"cash-out" refinances, where the motive is to raise cash. Suppose that in
raising $5,000 this way, Doe has to accept a 7% loan as replacement for his
current 6% loan, and $5,000 in refinance costs that are tacked on to his loan
balance. The tangible benefit of $5,000 in cash is clear, but is it a net
benefit?
There is no objective way for the lender to
answer the question. The price seems high, but maybe the borrower needs the
$5,000 to pay for life-saving medicine for his children? Again, the answer is in
the head of the borrower.
I t could be argued that whether or not there
is a net benefit also should depend on the borrower�s options. If the borrower
could raise the $5,000 elsewhere at a much lower cost, the finding should be
that there is no net benefit. It is neither feasible nor fair, however, to make
lenders responsible for assessing their customers� options.
The Net Tangible
Benefit in a Payment-Reduction Refinance
Some borrowers are willing to pay a stiff
price, in the form of wealth reduction in the future, in order to reduce their
monthly payments now. Frequently this involves converting a fixed-rate loan into
an adjustable carrying a lower rate, often with an interest-only option, for a
limited period. Costs are usually tacked on to the balance.
Whether there is a net benefit depends in
good part on how critical it is to the borrower to lower the payment. Perhaps
the alternative to a payment reduction is default. Only the borrower knows.
The Net Tangible
Benefit in a Risk-Reduction Refinance
With interest rates widely expected to rise,
many holders of adjustable rate mortgages (ARMs) are considering converting them
to fixed-rate mortgages (FRMs). The borrowers making the switch are willing to
pay a higher rate now in exchange for future rate certainty. On this issue,
lenders are in no position to substitute their judgment for the borrower�s.
In sum, regardless of why borrowers
refinance, the question of whether they receive a net benefit from it is for
borrowers alone to answer. Lenders do not have the information needed to
second-guess them.
On the other hand, borrowers often make their
decisions on the basis of incomplete and sometimes misleading information.
Instead of requiring lenders to assume responsibility for borrowers� decisions,
let�s make them responsible for providing borrowers with the information they
need to make their own decisions.
The formulation of disclosure rules has long
been viewed as a proper responsibility of Government, since this is the only way
to assure uniformity of disclosures across the market. But the Federal
Government has proven it is not up to this task. The existing mandatory
disclosure rules are obsolete and shamefully inadequate. Every attempt to fix
them gets bogged down in political in-fighting. It is time to try another
approach. Keep tuned.
Copyright Jack Guttentag 2005
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