How could someone refinance an existing mortgage?

Question

I'm reading Value: The Four Cornerstones of Corporate Finance (p. 8), and in the first chapter it talks about the financial crisis in the housing market, quote:

First, homeowners and speculators bought homes—essentially illiquid assets. They took out mortgages with interest set at artificially low teaser rates for the first few years, but then those rates rose substantially. Both the lenders and buyers knew that buyers couldn't afford the mortgage payments after the teaser period. But both assumed that either the buyer's income would grow by enough to make the new payments, or the house value would increase enough to induce a new lender to refinance the mortgage at similarly low teaser rates.

What I don't understand is the last part. How could a new lender refinance an existing mortgage while also make the adjustable rate lower?

Answer 1

You wouldn't refinance the existing mortgage. You would pay off the existing mortgage in full using the money from the new one.

Suppose you have a house valued at $100K, and a mortgage of $90K, that you can't pay. But the house has gone up in value to $150K. You take out a new mortgage for $130K, pay off the $90K, and have $40K to spend however you like. Maybe a new car.

If you then find you can't make the payments on the new mortgage, then no problem. The house has gone up to $180K. So take out a mortgage of $150K. Pay off the $130K mortgage, and you have another $20K to spend.

It all works right up to the point when house prices stop rising.

Answer 2

These mortgages had very little equity, and they effectively were negatively amortized, in that the initial interest rates were lower than the actual market rates. But if housing prices increased sufficiently, then the increase in equity would be able to offset the initial low down payment and the loss of effective equity from the teaser rates. When they went shopping for a new loan, the new, higher, equity would effectively be their down payment, and lenders would be willing to offer a lower rate because of that higher equity.

Answer 3

Usually, rates having dropped since the first mortgage. Plus some competition for your business, though that's a more minor effect. This is a matter of taking advantage of opportunities if and when they occur, not something that you can count on being able to do.

Rule of thumb is that when advertised interest rates are a full percentage point below the current mortgage, it is worth investigating refinancing. Less than that, and the fees are likely to keep it from being worth the effort.

Note that if rates have changed enough, you may be able to show your current bank this and ask if they would refinance you "in place" rather than lose you. This can be less hassle and involve lower fees

Example: When I bought my house, right around the start of the "mortgage crisis", mortgage rates were hovering around 6.5%. A few years later they had dropped to 4.5% and I refinanced. A few years after that they had dropped to the remarkably low 3.25% and I refinanced again, and kept that rate for the remainder of the mortgage period. But there was never any guarantee that things would work out this way: rates could have stayed higher.

Answer 4

At least here in the UK, where mortgage affordability rules are significant, you get a better rate on a lower loan-to-value ratio. The original mortgage was priced at 90% LTV. Even if you haven't paid any off by the time the house has risen to 180k, you've now only got 50% LTV, which will get you a more attractive interest rate. That can make up for a rise in the rates on the market.

Plus when you remortgage, you start a new contract, which can even run for longer than your original term. This can reduce your monthly payments (though the lifetime cost goes up)

We also typically have discounted or fixed rates for the first few years, with tight rules on locking people into the higher variable follow-on rate. So it's normal to take out a mortgage with a 5 year fixed rate and a 30-year term, and remortgage after 5 years. The fees for doing so are far less than the avoided cost of carrying on at the old rate. Last time I did this, it was with the same bank, and almost seamless (but I have a good enough LTV that I'm low risk)

Answer 5

The common phrase “refinance a mortgage” actually means “pay off one or more existing mortgages (generally you have to pay off any secondary liens as well) and get a new mortgage/loan with different terms (start date, interest rate, length of loan, etc) where the new lender is typically, but not always, different”. You can see why it’s shortened to refinance.

It is actually possible to change the terms of an existing mortgage/loan, this is known as restructuring a loan. It can NOT be done by a 3rd party. It is typically used to avoid bankruptcy or some other event that would result in nonpayment, although there is nothing preventing it from being used for reasons that would be considered “positive”.

Answer 6

The good faith explanation is that a mortgage rate has several components, such as market rate, risk factor and profit. The risk factor is closely tied to the ratio between asset value and mortgage. A $90K loan for a $100K asset is pretty safe, until prices drop by more than 10%. But if the asset becomes more valuable, e.g. prices rise to $120K, then even a 25% price drop still means that the lender has sufficient collateral.

Hence, lenders might get an initial teaser rate that does not properly account for the high initial risk.