Mortgage refinancing: options, benefits, and considerations

Mortgage Refinancing

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.

Introduction:

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 be relatively higher and so there is the risk of payments increasing sharply should interest rates increase. However, the possibility of interest rates rising considerably within a short span is quite low. If interest rates fall, the monthly payments will also be lower and there is the option to close off the loan in a shorter period. Generally, the adjustable interest rates are slightly lower than the fixed interest rates and hence the borrower can have savings even if the interest rates remain stable. An analysis of the interest rate movements in recent years of many countries would reveal that interest rates are either falling or stable. Under this scenario, the adjustable-rate mortgage refinancing is a better option for the short-term. However, there is a risk involved and it is upto the risk taking ability of the borrower that will lead to the final decision.

The principle of self-interested behaviour:

The decision to refinance a home is often described by this theory. In refinancing, the borrower often ends up taking a higher loan amount. This means that she has to compensate either by increasing the monthly payments or extending the term of repayment. Unless the entire loan is paid off with interest, the property will be under the charge of lenders. For people who prefer to have hassle-free ownership of the asset, refinancing may not be a desirable option. On the other hand, those who need funds and look for better returns, consider refinancing as a good opportunity. The decision to refinance is therefore said to be relaed to self-interested behaviour. Economic theory suggests that a typical owner would rationally examine all available financing alternatives before deciding on refinancing.

If there is another alternative that pays off better than refinancing of mortgage, it is more likely that the homeowner would not go in for refinancing. However, it is pointed out that it is not always easy for the homeowner to evaluate or accurately estimate future cash flows due to the uncertainties such as fluctuating interest rates. If this is the case, then the homeowner would still opt for refinancing even if other more viable options are available. Even in this case the decision could still be based on self-interest, that is the interest to protect from unknown or indeterminable risks. It is also very much possible that the homeowner may lack the knowledge or plainly uninterested to understand the value of the refinancing schemes and stick to the original financing plans. The major drawback of the self-interested behaviour is that it does not take account of the overall economics of financial decisions.

The principle of incremental benefits:

Decision to invest is often driven by the opportunity of incremental benefits than an asset can offer by making additional investment. A typical example is the expansion of plant capacity in manufacturing sector based on expectation of higher revenues. It may so happen that this decision can actually increase the profitability of the business than it was before expansion. Home-borrowers go in for refinancing due to the incremental benefits it offers over and above repaying the outstanding loans. There is additional loan available, which can be used for a variety of gainful purposes. In fact, it is not common for homeowners to attempt to increase their wealth by using the option of refinancing to raise capital. The principle of incremental benefits contends that mortgage refinancing will find favour as long as it can offer higher level of benefits to the borrowers. But this principle suffers from the fact that it is difficult to estimate the incremental benefits, especially future benefits. For example, under an adjustable rate loan scheme for refinancing, if interest rates were to rise in future, there would be little or no incremental benefits. Also this principle may not apply universally in the sense that the perception of incremental benefits may vary from individual to individual. This approach is often criticised since it does not take into account psychological factors such as moral principles, family values etc.

Risk-return tradeoff:

Financial decisions are often complex since they involve evaluation of multiple options under different scenarios. Each option will have its own risk-return profile and the decision maker would normally prefer to select that option which provides the maximum return at the same time having least risk. But as a general rule, return on an investment will be in proportion to the risk involved - greater the risk, higher the expected return. It is for the decision-maker to determine the extent of risk she can afford to take and be satisfied with the corresponding return. In the case of mortgage refinancing, the monthly payments and the term of repayment can increase, if the homeowner wants to stick to the minimum payments.

The obvious solution is to increase the monthly payments and reduce the term. Refinancing is favourable to the borrower as long as the interest rates are dropping or at best constant. But once the interest rates start rising and the refinance is based on variable or adjustable interest rates, then the borrower will have to make higher payments. These are the risk factors that the borrower will have to reckon at the time of refinancing. A perceived drawback of this principle is that it focusses only on economic factors and based on assumptions, estimates and analysis. It ignores the psychological factors such as emotion, sentiment and other non-economic factors which are invariably intertwined in mortgage financing decisions.

Time Value of Money:

This is one of the fundamental principles of finance. The value of money at a point of time is generally higher than its value at a future point of time, especially in an economy where inflation results in price increases with passage of time. People prefer current benefits to future and the money available at present can be employed to earn positive returns. Mortgage refinancing puts money in the hands of the borrower, which has got more value, according to the principle of time value of money. This is because equity is made available at the present time and the loan will have to be amortized over a long time horizon. To evaluate the cost vs. benefit, the sum of all cash outflows (monthly payments) will have to be discounted and converted to the present value., i.e the value at the time of time refinancing. If the equity provided by the refinancing is significantly higher than the present value of cash outflows, then it is better to take up refinancing of the mortgage.

Under ideal conditions, a homeowner is expected to apply the cost of time value of money to decide on refinancing and whether to go in for fixed-rate mortgage or adjustable-rate mortgage. The advantage with this principle is that it attempts to estimate the exact financial value for the refinancing option and gives a measurable parameter to enable the homeowner to take a decision. It takes into account the loss of money's value over the years and also provides for calculation of interest rates accurately. However, the drawback in this principle is that it is based on assumptions, which may be difficult to validate. For instance, the perceived value of a house may be many times more in future but this element cannot be captured in this approach. From the perspective of time value of money, refinancing is very attractive if done within the first few years of the original mortgage finance, particularly at lower interest rates.

Home ownership and mortgage refinancing:

According to a survey conducted on home ownership and the incidence of mortgage debt, there is an increasing trend of people owning homes (Brady, Canner and Maki, 2000). In the United States, a first half 1999 survey reported that 67% of all households owned their homes. Almost 60% of the homeowners were repaying loans taken to purchase their first homes. The survey also revealed that mortgage refinancing was on the upswing, with 47% of homeowners with debt choosing the option of refinancing their homes. The main reasons for the preference of refinancing are lower interest rates, changing dynamics of lending that have led to lower transaction costs, gains in house property values and equity. The survey noted that the refinancing of mortgage has a significant correlation to interest rates - 42% of the surveyed homeowners who took up refinancing, representing approximately 8.3 million homeowners, did so in 1998 or the first half of 1999, when interest rates were relatively lower over a sustained period.

An interesting finding of the survey is that during the boom years (characterised by low interest rates) in 1993 and 1998, the mortgage refinancing transactions far exceeded the primary home-purchase loans. In the intervening years, fresh home loans were more in number, indicating that the home owners were well quipped to take rational and economically sound decisions based on changing environmental conditions. The survey pointed out that homeowners who have opted for refinancing tend to accumulate more debt than those who did not - 47% had refinanced mortgages, but 55% of the outstanding debt were to the account of refinance lenders. The 1999 survey claimed that most of the homeowners (92%) were successful in obtaining lower interest rates, with average interest rates falling from 8.4% to 7.1% at the end of the survey period.

A surprising finding of the study is the marked shift to fixed-rate interest from adjustable rates. 29% of the respondents had adjustable rate mortgage schemes before refinancing, of which 75%, representing 21% of all refinanced accounts, converted to fixed-rate schemes at the time of refinancing. The justification for this trend can be understood from the fact that more than two-thirds of the homeowners who refinanced their mortgages extended the term of loan. From the survey results, it was found that 35% of the respondents used the refinancing opportunity to liquefy some portion of the home equity, which is due to the spiralling prices of home property. 52% of the homeowners who refinanced in 1998-1999 found themselves paying lower monthly dues after taking the new loan. Among those who liquefied equity, only 26% had lower monthly payouts, as most of the homeowner accepted additional debt at the time of refinancing.

When it came to use of the additional funds raised out of refinancing, 45% used the funds to repay other debts, 40% for home improvements, 12% for investments in stock markets or other financial instruments and 10% in real estate or business investments. As much as 39% of the respondents said that they used the extra funds to buy vehicles, fund vacations, education and medical expenses, which indicated the willingness of people to use refinancing as a means to fund short-term expenses. To have an idea of what extent of savings was achieved, the survey results were aggregated and balanced for change in interest rates and longer maturity periods. It was found that, refinancings in 1998 and first half of 1999 resulted in aggregate yearly mortgage payments by about U.S.$5.6 billion or approximately 680 per typical refinanced homeowner.

Following the boom of 1998-99, economies slipped into recession in 2001 and during this time, the housing market showed remarkable resilience. High home costs, lower interest rates and softer lending terms enabled households to reduce monthly payments on the refinanced mortgage. For instance, a borrower who took a loan for U.S.$150,000 in the year 2000 and opted for refinancing in mid-2003, saved upto U.S. $304 per month on payments (FRBSF Economic Letter, 2003). In addition to this, many owners liquefied equity from the rising values of their homes by securing refinance for substantially higher amounts.

Refinancing of mortgage loans based on reduction in interest rates does have its problems too. From an economic viewpoint, the lower outgo will mean reduced returns for the lenders. This could result at some point of time lenders try to improve their returns by imposing certain restrictive measures to counter the effect of multiple refinancings. For quite some years in the past, borrowers were able to refinance home mortgages as much as once in three months. However, of late, lenders are imposing penalties for early refinance to control unscrupulous use of this facility. (Lindstrom, 2001). The penalty could be in the range of 1-2%, although lenders are flexible to the changing market conditions.