Borrowers refinance for three reasons: to raise cash, to reduce monthly payments, or to lower interest costs.
Refinancing at a higher interest rate in order 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 in order 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 doesn't expect it to fix this problem anytime soon. Meanwhile, you can compare the cost of a cash-out refinance and a second mortgage using calculator 3d at www.mtgpro-fessor.com.
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, yet hardly a week goes by that I don't hear from confused homeowners who are being badgered by snake oil salesmen trying to convince them that their higher rates actually cost less.
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