Refinancing That Makes You Poorer

May 16, 2005, Revised December 1, 2006, April 28, 2009, September 5, 2010

Of every 10 letters I receive asking my opinion of a proposed refinance, I advise 7 or 8 that the refinance would make them poorer. My letters are not from a cross-section of prospective mortgage borrowers, so perhaps the comparable figure over the market generally is 3 or 4. That still qualifies as a mass seduction. Although borrowers participate willingly, many will regret their decisions in the morning.

In most markets, bad decisions can safely be ignored because the costs of mistakes are small and people learn from them; the second and third times around, they make better decisions. In the mortgage market, however, transactions are large and infrequent, so mistakes are much more costly.

What Is a Bad Refinance Decision?

It is a decision that results in the borrower being poorer in the future than he would have been had he not refinanced. It also can mean raising money at a cost well above that of readily available alternatives. Here is an example of the first:

Smith has a fixed-rate mortgage with a balance of $164,000 at 5.375%, and with 18 years to go. She refinances into a 5–year adjustable rate mortgage at 5.875% that is interest only (IO) for 5 years. This reduces her monthly payment from $1186 to $803, or by $383.

Over 5 years, the new IO mortgage will save $23,012 in payments, but the balance will be $164,000, the same as now. Had Smith retained her original mortgage, the balance would be paid down to $132,975, a reduction of $31,025. After 5 years, Smith would be $8,013 poorer.

Hucksters argue that Smith could invest the payment savings, but few consumers have either the discipline or investment skills needed to pull this off successfully. Smith would have to earn 11.64% just to break even. For most consumers, amortizing a mortgage remains the best way to save.

Why do people make so many bad refinance decisions? The three major reasons are borrower shortsightedness, meretricious mortgages, and the dysfunctional incentive systems of loan providers.

Borrower Shortsightedness

The great majority of those who make bad refinance decisions are either payment-myopic or cash-dazzled. Smith in my example was payment-myopic -- she focused on the amount she had to pay every month and ignored how much she owed.

Cash-dazzled borrowers are equally short-sighted, but their focus is on the cash they raise with a "cash-out" refinance. Often they have no idea what that cash is costing them. Here is an illustration:

Jones has a fixed-rate mortgage with a balance of $190,000 at 5.75%, and with 28 years to go. Jones needs $16,000 in cash and refinances into a 6.50% mortgage for $206,000. Jones believes he is paying 6.5% on his $16,000, which is why he chose it rather than a second mortgage available at 7.5%.

But Jones fails to take account of the increase in the rate on $190,000. When that is added in, the cost of the $16,000 raised with a cash-out refinance increases to almost 12%, or well above the cost of a second mortgage. See Cash-Out Mortgage Refinance or Home Equity Loan?

Meretricious Mortgages

Meretricious, meaning "falsely attractive", was originally applied to London street walkers, who appeared attractive in the shadows but not so good in the light. Some mortgages are like that.

Adjustable rate mortgages (ARMs) with an interest-only option, and especially the flexible-payment or option ARM, have exploded in popularity recently. While these ARMs have legitimate applications, the surge in popularity is due to their appeal to payment myopic borrowers. These mortgages reduce payments now, and extract their pound of flesh later. See Tutorial on Option ARMs. September 5, 2010 Comment: Option ARMs are no longer available in the post-crisis market,

Dysfunctional Incentive Systems

Most borrowers will shy away from loan providers who charge for information – such as information on whether the borrower will really benefit from a refinance. As a result, with very few exceptions, loan officers and mortgage brokers get paid only if a loan closes.

I know mortgage brokers who will not refinance a borrower who cannot benefit from it. The broker’s reward can be a future referral from a grateful borrower, but in most cases the reward is received in heaven.

Such people are treasures but they comprise a small part of the market. The rest are hell-bent to close loans. They reinforce borrower shortsightedness and leave the meretricious mortgages in the shadows.

How do you avoid being seduced? Check my tutorials on interest-only and option ARMs. They can show what it may cost you tomorrow to lower your payment today. Tutorial-phobic borrowers should take advantage of the 3-day right of rescission to reconsider their deal, preferably with the help of a knowledgeable third party. See Rescinding a Mortgage Refinance. In addition, I have 6 refinance calculators (3a through 3f) designed to quantify the costs and benefits of refinancing under a variety of circumstances. See Mortgage Calculators.

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