Monthly Archives: August 2012
Mortgage refinancing refers to the replacement of an existing debt obligation with a debt obligation under different terms. The terms and conditions of home mortgage refinancing may vary widely by country, province, or state, based on several economic factors such as, inherent risk, projected risk, political stability of a nation, currency stability, banking regulations, borrower’s credit worthiness, and credit rating of a nation. In many industrialized nations, a common form of refinancing is for a place of primary residency mortgage. If the replacement of debt occurs under financial distress, refinancing might be referred to as debt restructuring.
A loan (debt) might be refinanced for various reasons:
- To take advantage of a better interest rate (a reduced monthly payment or a reduced term)
- To consolidate other debt(s) into one home loan (a potentially longer/shorter term contingent on interest rate differential and fees)
- To reduce the monthly repayment amount (often for a longer term, contingent on refinance interest rate differential and fees)
- To reduce or alter risk (e.g. switching from a variable-rate to a fixed-rate loan)
- To free up cash (often for a longer term, contingent on interest rate differential and fees)
Refinancing for reasons 2, 3, and 5 are usually undertaken by borrowers who are in financial difficulty in order to reduce their monthly repayment obligations, with the penalty that they will take longer to pay off their debt.
In the context of personal (as opposed to corporate) finance, refinancing multiple debts makes management of the debt easier. If high-interest debt, such as credit card debt, is consolidated into the home mortgage, the borrower is able to pay off the remaining debt at mortgage rates over a longer period.
For home mortgages in the United States, there may be tax advantages available with refinancing, particularly if one does not pay Alternative Minimum Tax.
Most fixed-term loans have penalty clauses (“call provisions”) that are triggered by an early repayment of the loan, in part or in full, as well as “closing” fees. There will also be transaction fees on the refinancing. These fees must be calculated before embarking on a loan refinancing, as they can wipe out any savings generated through refinancing. Penalty clauses are only applicable to loans paid off prior to maturity. If a loan is paid off upon maturity it is a new financing, not a refinancing, and all terms of the prior obligation terminate when the new financing funds to pay off the prior debt.
If the refinanced loan has lower monthly repayments or consolidates other debts for the same repayment, it will result in a larger total interest cost over the life of the loan, and will result in the borrower remaining in debt for many more years. Calculating the up-front, ongoing, and potentially variable costs of refinancing is an important part of the decision on whether or not to refinance.
In some jurisdictions, varying by American state, refinanced mortgage loans are considered recourse debt, meaning that the borrower is liable in case of default, while non-refinanced mortgages are non-recourse debt.
Refinancing lenders often require a percentage of the total loan amount as an upfront payment. Typically, this amount is expressed in “points” (or “premiums”). 1 point = 1% of the total loan amount. More points (i.e. a larger upfront payment) will usually result in a lower interest rate. Some lenders will offer to finance parts of the loan themselves, thus generating so-called “negative points” (i.e. discounts).
Borrowers with this type of refinancing typically pay few if any upfront fees to get the new mortgage loan. This type of refinance can be beneficial provided the prevailing market rate is lower than the borrower’s existing rate by a formula determined by the lender offering the loan. Before you read any further do not provide any lender with a credit card number until they have provided you with a Good Faith Estimate verifying it is truly a 0 cost loan. The appraisal fee cannot be paid for by the lender or broker so this will always show up in the total settlement charges at the bottom of your GFE.
This can be an excellent choice in a declining market or if you are not sure you will hold the loan long enough to recoup the closing cost before you refinance or pay it off. For example, you plan on selling your home in three years, but it will take five years to recoup the closing cost. This could prevent you from considering a refinance, however if you take the zero closing cost option, you can lower your interest rate without taking any risk of losing money.
In this case the broker receives a credit or what’s called yield spread premium (YSP). Yield spread premiums are the cash that a mortgage company receives for originating your loan. The broker provides the client and the documentation needed to process the loan and the lender pays them for providing this service in lieu of paying one of their own loan officers. Since a brokerage can have more than one loan officer originating loans, they can sometimes receive additional YSP for bringing in a volume amount of loans. This is normally based on funding more than 1 million in total loans per month. This can greatly benefit the borrower, especially since April 1, 2011. New laws have been implemented by the federal government mandating that all brokers have set pricing with the lenders they do business with. Brokers can receive so much YSP that they can provide you with a lower rate than if you went directly to the lender and they can pay for all your closing cost as opposed to the lender who would make you pay for all the third party fees on your own. You end up with a lower rate and lower fees. Since the new RESPA law as of April came into effect in 2011, brokers can no longer decide how much they want to make off of the loan. Instead they sign a contract in April stating that they will keep only a certain percentage of the YSP and the rest will go toward the borrowers closing cost.
True No Closing Cost Mortgages are usually not the best options for people who know that they will keep that loan for the entire length of the term or at least enough time to recoup the closing cost. When the borrower pays out of pocket for their closing costs, they are at a higher risk of losing the money they invested. In most cases, the borrower is not able to negotiate the fees for the appraisal or escrow. Sometimes, when wrapping closing costs into a loan you can easily determine whether it makes sense to go with the lower rate with closing cost or the slightly higher rate for free. Some cases your payment will be the same, in that case you would want to choose the higher rate with no fees. If the payment for 4.5% with $2,500 in settlement charges is the same for 4.625% for free then you will pay the same amount of money over the length of the loan, however if you choose the loan with closing cost and you refinance before the end of your term you wasted money on the closing cost. Your loan amount will be 2,500 less at 4.625% and your payment is the same.
This type of refinance may not help lower the monthly payment or shorten mortgage periods. It can be used for home improvement, credit cards, and other debt consolidation if the borrower qualifies with their current home equity; they can refinance with a loan amount larger than their current mortgage and keep the cash out.