Under the Federal Truth in Lending Act, borrowers who refinance a loan on their primary residence with a lender other than their current lender can cancel the deal at no cost to themselves within three days of closing. This “right of rescission” is designed to give borrowers who may have been sweet-talked into a transaction an opportunity to think it over and, if they decide the deal is not really in their interest, to back out.
The right of rescission is only valuable to borrowers if they use the 3-day period to reflect on all the costs and benefits of the transaction, preferably having it scrutinized by an objective third party. My own experience suggests that this rarely happens. I receive very few letters from refinancing borrowers soliciting my help within the 3-day period. I receive many letters from borrowers, long after their rescission period ended, asking what recourse they have against the loan provider who abused them!
A third party can never say conclusively that a particular deal is not in a borrower’s interest. Only the borrower can make that decision. But it is possible to rate the different kinds of refinance transactions by the likelihood that the borrowers will regret what they did. I’ll use a scale from 0 (lowest regret potential, or RP) to 100 (highest RP). The scale is completely subjective.
RP – 5: Refinancing from an adjustable to a fixed-rate mortgage (FRM) probably has the lowest regret potential of all refinance transactions. The borrower incurs transaction costs and accepts a higher interest rate in order to get rate stability. Borrowers who do this are already looking to the future and are unlikely to regret their actions.
RP – 10: Refinancing into the same type of mortgage in order to lower the interest rate also has low regret potential. The benefit of the lower rate is evident, and the only issue that arises is whether the savings will exceed the transactions costs over the period the borrower expects to hold the mortgage. To help with that issue they can use calculator 3a on my Web site.
RP – 25: Refinancing two mortgages to lower the rates is more complex, increasing the possibility of error and the potential for regret. Borrowers can use my calculator 3b to help them.
RP – 30: Refinancing from one mortgage to two to get rid of mortgage insurance is tricky because the mortgage insurance premium is not comparable to the interest rate. But my calculator 3c makes them comparable.
RP – 50: Refinancing from a fixed-rate to an adjustable-rate mortgage (ARM) in order to lower the mortgage payment has significant regret potential. To obtain lower payments now, the borrower is risking higher payments in the future. Borrowers should examine what might happen to their payment in the event of a significant increase in market rates, and whether they could deal with it. My calculators 7b, 7c and 7ci are designed to answer these questions.
An interest rate on their existing FRM that is below the current market rate is a warning sign. It means that the market values their new loan less than their old loan.
RP – 75: Refinancing to get “cash-out” has even higher regret potential. This includes loans for the purpose of consolidating other debts. Sometimes, borrowers do a cash-out refinance when they would have done better with a second mortgage. This is usually the case when the rate on the new cash-out loan is higher than the rate on the old loan. The borrower who wants to check this can use my calculator 3d.
Cash-out deals reduce the borrower’s equity in the house, sometimes eliminating it altogether. Having no equity means the house can’t be sold without coming up with the cash needed to pay off the mortgage and pay the transaction costs. A warning sign is an appraisal that the borrower knows to be inflated.
RP – 100: Cash-out refinance when there are two existing mortgages has the highest regret potential. The likelihood that the transaction will eliminate the borrower’s equity is greater when there are two mortgages. Further, with two mortgages, there is a wider array of possible transactions that ought to be compared.
Both existing mortgages could be refinanced into one new mortgage with cash-out. Alternatively, the first mortgage could be refinanced alone, or the second could be refinanced alone. My calculators 1b and 1c will help sort out these choices.
Congress gave borrowers the right of rescission so they could escape from bad deals. It only works, however, if borrowers use the rescission period for sober second thought.
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.
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