Bad Financing

Bad refinance decisions comes back to haunt borrowers

Of every 10 letters I receive asking my opinion of a proposed refinance, I advise seven or eight that the refinance would make them poorer. My letters are not from a cross-section of prospective borrowers, so perhaps the comparable figure over the market generally is three or four. 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/she would have been had he/she 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 percent, and with 18 years to go. She refinances into a 5-year adjustable-rate mortgage at 5.875 percent that is interest only (IO) for 5 years. This reduces her monthly payment from $1,186 to $803, or by $383.

Meretricious Mortgages:

Meretricious, meaning "falsely attractive," was originally applied to London streetwalkers, 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.

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. And don't respond to solicitations!

The writer is Professor of Finance Emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at www.mtgprofessor.com.