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April 8, 2002, Revised November 17,
2004
"Does it ever make sense to refinance
into a mortgage carrying a higher interest rate than the mortgage you already
have?"
Very often it does not. Mortgage borrowers
refinancing at higher rates ought to use the 72 hour right-to-rescind period to
ask themselves if the deal is really in their best interest. See
Rescinding a Mortgage Refinance.
Mortgage 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.
Refinancing a Mortgage to Raise 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 my calculator 3d.
Refinancing a Mortgage to Reduce 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, along with a higher rate,
to get the payment down.
Refinancing at a higher rate in this
situation is justified because the alternative is default. Nonetheless, the
inability to modify the terms of existing mortgages is a weakness of the present
system.
Refinancing a Mortgage to Reduce Interest Costs
If the
purpose is to reduce 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.
Copyright Jack Guttentag 2004
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