Term Paper: Mortgage Refinancing

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[. . .] However, the possibility of interest rates rising considerably within a short span is quite low. If interest rates fall, the monthly payments will also be lower and there is the option to close off the loan in a shorter period. Generally, the adjustable interest rates are slightly lower than the fixed interest rates and hence the borrower can have savings even if the interest rates remain stable. An analysis of the interest rate movements in recent years of many countries would reveal that interest rates are either falling or stable. Under this scenario, the adjustable-rate mortgage refinancing is a better option for the short-term. However, there is a risk involved and it is upto the risk taking ability of the borrower that will lead to the final decision.

The principle of self-interested behaviour:

The decision to refinance a home is often described by this theory. In refinancing, the borrower often ends up taking a higher loan amount. This means that she has to compensate either by increasing the monthly payments or extending the term of repayment. Unless the entire loan is paid off with interest, the property will be under the charge of lenders. For people who prefer to have hassle-free ownership of the asset, refinancing may not be a desirable option. On the other hand, those who need funds and look for better returns, consider refinancing as a good opportunity. The decision to refinance is therefore said to be relaed to self-interested behaviour. Economic theory suggests that a typical owner would rationally examine all available financing alternatives before deciding on refinancing.

If there is another alternative that pays off better than refinancing of mortgage, it is more likely that the homeowner would not go in for refinancing. However, it is pointed out that it is not always easy for the homeowner to evaluate or accurately estimate future cash flows due to the uncertainties such as fluctuating interest rates. If this is the case, then the homeowner would still opt for refinancing even if other more viable options are available. Even in this case the decision could still be based on self-interest, that is the interest to protect from unknown or indeterminable risks. It is also very much possible that the homeowner may lack the knowledge or plainly uninterested to understand the value of the refinancing schemes and stick to the original financing plans. The major drawback of the self-interested behaviour is that it does not take account of the overall economics of financial decisions.

The principle of incremental benefits:

Decision to invest is often driven by the opportunity of incremental benefits than an asset can offer by making additional investment. A typical example is the expansion of plant capacity in manufacturing sector based on expectation of higher revenues. It may so happen that this decision can actually increase the profitability of the business than it was before expansion. Home-borrowers go in for refinancing due to the incremental benefits it offers over and above repaying the outstanding loans. There is additional loan available, which can be used for a variety of gainful purposes. In fact, it is not common for homeowners to attempt to increase their wealth by using the option of refinancing to raise capital. The principle of incremental benefits contends that mortgage refinancing will find favour as long as it can offer higher level of benefits to the borrowers. But this principle suffers from the fact that it is difficult to estimate the incremental benefits, especially future benefits. For example, under an adjustable rate loan scheme for refinancing, if interest rates were to rise in future, there would be little or no incremental benefits. Also this principle may not apply universally in the sense that the perception of incremental benefits may vary from individual to individual. This approach is often criticised since it does not take into account psychological factors such as moral principles, family values etc.

Risk-return tradeoff:

Financial decisions are often complex since they involve evaluation of multiple options under different scenarios. Each option will have its own risk-return profile and the decision maker would normally prefer to select that option which provides the maximum return at the same time having least risk. But as a general rule, return on an investment will be in proportion to the risk involved - greater the risk, higher the expected return. It is for the decision-maker to determine the extent of risk she can afford to take and be satisfied with the corresponding return. In the case of mortgage refinancing, the monthly payments and the term of repayment can increase, if the homeowner wants to stick to the minimum payments.

The obvious solution is to increase the monthly payments and reduce the term. Refinancing is favourable to the borrower as long as the interest rates are dropping or at best constant. But once the interest rates start rising and the refinance is based on variable or adjustable interest rates, then the borrower will have to make higher payments. These are the risk factors that the borrower will have to reckon at the time of refinancing. A perceived drawback of this principle is that it focusses only on economic factors and based on assumptions, estimates and analysis. It ignores the psychological factors such as emotion, sentiment and other non-economic factors which are invariably intertwined in mortgage financing decisions.

Time Value of Money:

This is one of the fundamental principles of finance. The value of money at a point of time is generally higher than its value at a future point of time, especially in an economy where inflation results in price increases with passage of time. People prefer current benefits to future and the money available at present can be employed to earn positive returns. Mortgage refinancing puts money in the hands of the borrower, which has got more value, according to the principle of time value of money. This is because equity is made available at the present time and the loan will have to be amortized over a long time horizon. To evaluate the cost vs. benefit, the sum of all cash outflows (monthly payments) will have to be discounted and converted to the present value., i.e the value at the time of time refinancing. If the equity provided by the refinancing is significantly higher than the present value of cash outflows, then it is better to take up refinancing of the mortgage.

Under ideal conditions, a homeowner is expected to apply the cost of time value of money to decide on refinancing and whether to go in for fixed-rate mortgage or adjustable-rate mortgage. The advantage with this principle is that it attempts to estimate the exact financial value for the refinancing option and gives a measurable parameter to enable the homeowner to take a decision. It takes into account the loss of money's value over the years and also provides for calculation of interest rates accurately. However, the drawback in this principle is that it is based on assumptions, which may be difficult to validate. For instance, the perceived value of a house may be many times more in future but this element cannot be captured in this approach. From the perspective of time value of money, refinancing is very attractive if done within the first few years of the original mortgage finance, particularly at lower interest rates.

Home ownership and mortgage refinancing:

According to a survey conducted on home ownership and the incidence of mortgage debt, there is an increasing trend of people owning homes (Brady, Canner and Maki, 2000). In the United States, a first half 1999 survey reported that 67% of all households owned their homes. Almost 60% of the homeowners were repaying loans taken to purchase their first homes. The survey also revealed that mortgage refinancing was on the upswing, with 47% of homeowners with debt choosing the option of refinancing their homes. The main reasons for the preference of refinancing are lower interest rates, changing dynamics of lending that have led to lower transaction costs, gains in house property values and equity. The survey noted that the refinancing of mortgage has a significant correlation to interest rates - 42% of the surveyed homeowners who took up refinancing, representing approximately 8.3 million homeowners, did so in 1998 or the first half of 1999, when interest rates were relatively lower over a sustained period.

An interesting finding of the survey is that during the boom years (characterised by low interest rates) in 1993 and 1998, the mortgage refinancing transactions far exceeded the primary home-purchase loans. In the intervening years, fresh home loans were more in number, indicating that the home owners were well quipped to take rational and economically sound decisions based on changing environmental conditions. The survey pointed out that homeowners who have opted for refinancing tend to accumulate more debt than those who did not - 47% had refinanced mortgages, but 55% of the outstanding… [END OF PREVIEW]

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Mortgage Refinancing.  (2004, March 31).  Retrieved April 20, 2019, from https://www.essaytown.com/subjects/paper/mortgage-refinancing/6649515

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"Mortgage Refinancing."  31 March 2004.  Web.  20 April 2019. <https://www.essaytown.com/subjects/paper/mortgage-refinancing/6649515>.

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"Mortgage Refinancing."  Essaytown.com.  March 31, 2004.  Accessed April 20, 2019.