Many borrowers who write me about refinancing are about to close on deals that would make them poorer.
I also receive mail from borrowers who realize they made a mistake when they refinanced earlier, asking how to undo the mistake or whether they have any recourse. The problem of refinances that involve no benefit to the borrower is associated with aggressive merchandising by mortgage brokers and loan officers (who I call "loan providers"). They drum up refinance business among borrowers who otherwise might never have given it a thought.
Interest-only mortgages and option ARMs are their tools of choice. The first line of their pitch is often some variant of "Mrs. Jones, how would you like to reduce your payment from $1,200 to $600?"
In prior articles in this six-part series on suitability standards (this is Part 4), I concluded that a suitability standard was not an effective way to prevent borrowers from being stuck with the wrong type of mortgage, or with a mortgage they could not afford.
Proponents of a suitability standard would make loan providers responsible for assuring that a refinance provides a net tangible benefit to the borrower. The "net" is critically important. All or virtually all refinanced mortgages provide some benefit, otherwise borrowers wouldn't do them.
Under a suitability rule, the loan provider must determine whether or not the benefit outweighs the cost. This responsibility, however, is beyond their competence. That's because borrowers refinance for different reasons.
Cost reduction: If the purpose of the refinance is to reduce the borrower's cost, the new interest rate or mortgage insurance premium must be lower than the existing one. Ordinarily, however, the borrower must incur an upfront cost.
For there to be a net benefit, therefore, the borrower must have the mortgage long enough for the monthly cost reductions to exceed the upfront costs of the refinance. Only the borrower has any idea of how long the mortgage may last.
Raising cash: Suppose the purpose of the refinance is to raise cash. The tangible benefit of the cash is clear, but the cost may be very high.
I recently reviewed a cash-out refinance in which the borrower paid about $12,000 in refinance costs and a quarter-percent rise in rate on a loan of $150,000, in order to raise $4,500 in cash. Was there a net benefit?
There is no objective way for the loan provider to answer the question. While the price was very high, maybe the borrower needed the cash to pay for life-saving medicine?
It could be argued that whether or not there is a net benefit also should depend on whether the borrower could raise the cash elsewhere at a lower cost. It is neither fair nor feasible, however, to make loan providers responsible for assessing their customers' options.
Reduce payment: If the purpose of the refinance is to reduce the mortgage payment, this almost always comes at the cost of a reduction in future wealth. 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.
Convert ARM into FRM: Suppose the purpose of the refinance is to convert rate uncertainty on an existing adjustable-rate mortgage into a fixed-rate mortgage. The borrowers making the switch are willing to pay a higher rate now in exchange for future rate certainty. Whether there is a net benefit depends in part on the value the borrower attaches to future rate certainty. Once again, loan providers 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. Loan providers 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 better decisions. I will discuss this idea further in a future column.
The writer is professor of finance emeritus at the Wharton School of the University of Pennsylvania. Send questions or comments to email@example.com.