There is a spurt of mortgage refinancing activity in recent times, thanks to interest rates remaining low and more or less consistent over a significant time horizon, appreciation of house prices and the easier refinancing options available in the market. This paper attempts to trace the various issues that influence the homeowner's decision to refinance. The pros and cons of 30-year mortgage vis-a-vis 15-year mortgage are discussed from different perspectives. From a homeowner's perspective the benefits and drawbacks of fixed-rate mortgage and adjustable-rate mortgage are analysed. This analysis is made with reference to basic financial principles - the self-interested behaviour, the principle of incremental benefits, risk-return trade-off and the time value of money. Refinancing makes available fresh capital to the homeowners giving them the opportunity to use it for spending or investing for returns.
Soft interest rates and increasing property prices in recent years have resulted in sharp rise in refinancing activity. For the lenders, the refinancing market represents a huge opportunity, which they can ill afford to ignore, especially in countries where home ownership is already peaking and the opportunities for financing first mortgages are becoming limited. During economic recession, refinancing provides a good option to raise money for those homeowners who are facing financial hardships. The pitfalls of mortgage refinancing are also highlighted. Case study analysis of mortgage refinancing is attempted to understand the market dynamics from a practical perspective. The paper traces the recent trends in mortgage refinancing in leading countries and the various forces that drive the refinancing market. It is evident that the refinancing business represents a huge market and will continue to grow in future. Given the right conditions, it will benefit both the homeowners and the lenders.
Mortgage is the loan given by financial institutions or banks for purchase of property in return for interest on the amount loaned. The term 'mort' means dead in French, implying that the borrower will have to kill off the loan, albeit slowly. The loan repayment is spread over a definite period and payment is usually made every month. The lender has the first lien on the property, till such time the loan is repaid. In the U.S., the common term for mortgage is 30 years, followed by 15-year term. The issue of which option is better is often debated. In strict financial sense, the 15-year option is better as the interest element in the 30-year mortgage, will be substantially higher. However, the 30-year option will mean lower monthly payments, which could mean higher affordability to the borrower.
Rates for fixed term of 30 years will be generally higher than the 15-year term. For the week ending March 29, 2004, the interest rate for 30-year fixed rate option was 5.4%, while for the 15-year mortgage it was 4.7%. (Mortgage Information Service, 2004). The tax benefits available for the interest portion of payments will be substantial and hence the net outgo to the borrower will be lower to that extent. This will be beneficial over the 30-year mortgage as interest rates for longer terms are generally higher. But there is a major drawback with the 30-year term loan. Since the interest element will be a major portion of the monthly payments, the net principal payable at the end of a certain period will be higher in the case of 30-year term. In other words, when it comes to selling the house after say five years or so, the 15-year mortgage would result in a situation where the principal outstanding is lower compared to the 30-year option, which is a significant advantage
Factors influencing mortgage refinancing:
There has been a growing interest in refinancing of home loans in recent years, thanks to rising housing prices and declining interest rates. Contrary to popular notion, it can be quite a difficult task to decide whether to refinance a mortgage and if yes, the appropriate point of time to do so. This requires a delicate balance of costs and benefits and dealing with both measurable and uncertain factors. The motivating factor in refinancing is the opportunity for homeowners to convert built-up capital into disposable funds. Another major advantage is that refinancing results in lower interest rates and hence lower monthly payments, which means that homeowners can either spend the extra money or save it. It is also possible to borrow more than the equity accumulated over the years and this gives the chance to improve existing assets, buy new assets or use the money for other purposes. Thus, there is an almost compulsive need for refinancing, if the interest rates on loans during a period of time drops below the homeowner's interest rate.
In this scenario, the homeowner has to evaluate the post-tax savings on the lower interest, refinanced loan payments compared to the post-tax costs of the refinancing. The benefits of lower monthly payments will be realised only after a substantial number of years and this has to be weighed against the current costs of refinancing transaction. Homeowners resort to refinancing, if they feel the need to reduce the term of repayment for personal reasons. Age of a person plays a major role in this factor - for example, most people would like to complete mortgage obligations before they retire from active work. By shifting to lower interest rates, the term of repayment would be cut down. On the contrary, there may be some people wanting to reduce the monthly payments due to existing or anticipated financial difficulties and thus willing to extend the term of mortgage.
There may also be instances when the interest rates on the first mortgage are already so low that there is no incentive for the homeowner to consider refinance. Another factor is the period of time, the borrower will own the home. If, for some reason, the borrower sells the home within a short time after refinancing, the savings in interest payments till that point of time may not be sufficient to cover the transaction costs. Yet another uncertain element is the assumption on future interest rates. If the homeowner feels that interest rates will fall with time, she may defer refinancing even if the benefits exceed costs. The decision to raise extra money through refinancing is often influenced by the cost of securing the same extent of finance through other available means of funding such as personal loans, credit cards etc. For example, if the bank interest rates on personal loans are equal to or higher than mortgage refinancing rates, then the homeowner sees justification in restoring to refinancing.
But, refinancing would result in the realisation of entire loan amount immediately and hence the interest becomes payable on the full amount with immediate effect. With credit card loans, it is possible to take funds only when needed, so that the interest rates are applicable only to the extent of the actual expenditure incurred. In this regard, the effect of taxation is to be taken into consideration. Tax laws of many countries, including the United States of America, support home loans by allowing interest payments as tax deductibles. Interest payments through credit and for other forms of debt are generally not granted tax concessions and thus the after-tax cost of raising money through mortgage refinancing will be lower than other that other types of loans.
Fixed or adjustable rates?
Mortgage financing or refinancing is available under fixed rate and adjustable rate schemes. As the name implies, the fixed rate scheme has the same rate of interest throughout the mortgage period, irrespective of external influences. The monthly payments are the same till the very last installment. On the other hand, the adjustable rate mortgage has interest rates moving in tandem with the prevailing interest rates offered by standard banks or financial institutions. So, the monthly payments can increase or reduce, depending on the movement of interest rates. Both the fixed-rate and adjustable-rate mortgage have advantages as well as drawbacks. Fixed rate scheme works best for borrowers who are averse to risks and want to be in control their liabilities at all times. It is also preferable when the exposure is large and the term in long, as there will not be a sharp jump in monthly payments when interest rates go up.
However, if interest rates fall continuously, then the borrower is stuck with higher rates and will continue to pay more money. The adjustable rate mortgage enables the borrower to enjoy the benefits of lower interest rates without loss of time. In a falling interest regime, this scheme is more advantageous and can significantly reduce the interest payments on the mortgage as well as the term. Borrowers who are confident of meeting the increase in monthly payouts, in case the interest rate increased can opt for adjusted rate mortgage schemes.
The term of mortgage can have an impact on the choice of interest-rate type. For a 5-year term, the savings of an adjustable rate scheme over the fixed-rate scheme may not be significant. Since the term is short, the monthly payments will…