Refinance: The Tangible Net Benefit Rule

18 April 2005, Revised December 1, 2006, July 9, 2007, October 24, 2010

"I understand that in pending Federal legislation aimed at predatory lending, lenders will be prohibited from refinancing a mortgage unless there is a ‘tangible net benefit’ to the borrower…Is this a good rule?"

The tangible net benefit rule applied to loans being refinanced would make lenders responsible for something over which they have little or no control.

All or virtually all refinanced mortgages provide tangible benefits, otherwise borrowers wouldn’t do them. A borrower who closes a refinance only to find that there is no benefit, has 3 days to rescind. Even predatory lenders, who are the focus of the proposed legislation, provide a benefit to the refinancing borrower.

The problem is that in exchange for the benefit, the predator extracts a pound of flesh. That’s why the proposed legislation requires a "net" benefit, meaning that the benefit outweighs the cost. Unfortunately, there is no way that a lender can determine this. Whether or not the benefit outweighs the cost in any particular case depends heavily on what is in the borrower’s head.

This will become clear from looking at the four main reasons that borrowers refinance: to reduce costs, raise cash, reduce monthly payments, and reduce interest rate risk.

The Net Tangible Benefit in a Cost-Reduction Refinance

A cost-reduction refinance is one in which the new interest rate or mortgage insurance premium is lower than the existing one. In most cases, however, the borrower incurs costs upfront. If there is to be a "net benefit", therefore, the future savings must outweigh the upfront costs.

But future savings depend, among other things, on how long the borrower expects to have the mortgage. This critical piece of information, if it is anywhere, is in the borrower’s head.

The Net Tangible Benefit in a Cash-Out Refinance

Some of the worst market abuses arise on "cash-out" refinances, where the motive is to raise cash. Suppose that in raising $5,000 this way, Doe has to accept a 7% loan as replacement for his current 6% loan, and $5,000 in refinance costs that are tacked on to his loan balance. The tangible benefit of $5,000 in cash is clear, but is it a net benefit?

There is no objective way for the lender to answer the question. The price seems high, but maybe the borrower needs the $5,000 to pay for life-saving medicine for his children? Again, the answer is in the head of the borrower.

It could be argued that whether or not there is a net benefit also should depend on the borrower’s options. If the borrower could raise the $5,000 elsewhere at a much lower cost, the finding should be that there is no net benefit. It is neither feasible nor fair, however, to make lenders responsible for assessing their customers’ options.

The Net Tangible Benefit in a Payment-Reduction Refinance

Some borrowers are willing to pay a stiff price, in the form of wealth reduction in the future, in order to reduce their monthly payments now. Frequently this involves converting a fixed-rate loan into an adjustable carrying a lower rate, often with an interest-only option, for a limited period. Costs are usually tacked on to the balance.

Whether there is a net benefit depends in good part on how critical it is to the borrower to lower the payment. Perhaps the alternative to a payment reduction is default. Only the borrower knows.

The Net Tangible Benefit in a Risk-Reduction Refinance

When interest rates are expected to rise, as was the case during much of 2005 and 20010, many holders of adjustable rate mortgages (ARMs) consider converting them to fixed-rate mortgages (FRMs). The borrowers making the switch are willing to pay a higher rate now in exchange for future rate certainty. On this issue, lenders are in no position to substitute their judgment for the borrower’s.

In sum, regardless of why borrowers refinance, the question of whether they receive a net benefit from it is for borrowers alone to answer. Lenders do not have the information needed to second-guess them.

On the other hand, borrowers often make their decisions on the basis of incomplete and sometimes misleading information. Instead of requiring lenders to assume responsibility for borrowers’ decisions, let’s make them responsible for providing borrowers with the information they need to make their own decisions.

The formulation of disclosure rules has long been viewed as a proper responsibility of Government, since this is the only way to assure uniformity of disclosures across the market. But the Federal Government has proven it is not up to this task. The existing mandatory disclosure rules are obsolete and shamefully inadequate. Every attempt to fix them gets bogged down in political in-fighting. It is time to try another approach. Keep tuned.

Taking the "Net" Out of Net Tangible Benefit

When I reread this article in 2010, it occurred to me that all the problems I cite hinge on the word "net". If that word was removed, the rule would be that any refinance must provide some benefit to the borrower: lower rate, lower payment, lower risk of rate increase, or cash-out. Such a rule would eliminate some of the most egregiously predatory transactions, and would do no harm because it would be clear and very easy to enforce. 

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