A commonly asked question is: why do banks allow refinancing? Not only do banks allow refinancing, they employ an army of loan officers actively seeking refinancing prospects. They don’t just allow it, they promote it!
You may see advertisements encouraging you to refinance your mortgage no matter what the economic environment:
- “Rates are low – now is a great time to refinance!”
- “Rates are rising – refinance now before it’s too late!”
The reasons behind why banks promote and allow refinancing should be a wakeup call for most borrowers. In my humble opinion most home-owners refinance far too frequently. It’s a far better deal for the banks than the borrowers.
If only they knew the multiple ways banks profit by allowing refinancing:
- Amortization schedules
- Closing fees
- Secondary markets
- Lending competition
Banks allow refinancing because interest amortization schedules are heavily front-loaded. Many borrowers mistakenly assume that if they have a loan with a six percent interest rate, then:
- Six percent of their monthly loan payment is the interest
- Ninety four percent is principle
Nothing could be further from the truth. When you see how amortization actually works you may be shocked – lenders don’t want borrower to hear this. Consider a one hundred thousand dollar, thirty year mortgage with a six percent interest rate. The picture below illustrates the percentage of your mortgage payment that is applied to interest and principle by year.
As you plainly see, during the first year of your mortgage:
- Eighty percent of their monthly loan payment is interest
- Twenty percent is principle
Loan closing fees are another reason why banks allow mortgage refinancing. Banks and their mortgage industry cohorts make a mint on a variety of fees associated with closing your loan. Keep in mind these fees get charged only when people are buying a home or refinancing. If you continue paying your original mortgage without refinancing they cannot assess and collect these fees.
Below are the fees charged on a recent mortgage closing on a loan for $175,000, and documented on the Settlement Statement (HUD-1):
- Origination charges – $1,256
- Appraisal fee – $400
- Credit report – $50
- Title services – $1,727
Granted the bank is not pocketing all these fees. Some of the money goes to other parties, but they all work together to bring in new customers to collectively gorge on a new round of transaction fees.
Secondary markets are the third reason banks allow mortgage refinancing. Back in the dark ages of mortgage lending banks held onto the loans they originated. Today is completely different. Mortgages (and other types of loans) are often quickly sold on the secondary market.
Banks have become mortgage applications processors. They employ an army of mortgage loan officers and documentation specialists who put together the complex paperwork needed to issue a mortgage. Once the paperwork is complete the bank often then sells the mortgage or loan to an investor, making a tidy profit on the transaction, and wiping their hands clean of any lending risk exposure.
Once the loan is sold to the investor it frees up capital to go and originate more mortgage loan applications. The sold mortgage is then stripped down into tranches: streams of principle and interest payments. These tranches are then packaged together into mortgage backed securities and resold to thousands of investors each holding only a small piece of your original mortgage or loan.
When the loan is refinanced there are three possible stakeholders:
- The originating bank – doesn’t care. They sold the loan.
- The principle strip owner – is very happy. The principle is repaid more quickly than projected.
- The interest strip owner – is not happy. The stream of interest payments ends.
Competition is the fourth reason banks allow refinancing. If you have a mortgage with Bank A, Bank B will be very eager to take your business away from Bank A. Banks make money by lending. This is what they do. If they can steal business away from a rival it helps them grow.
Some banks still hold onto some mortgages or other loans. Not every loan is sold on the secondary market. In the cases where Bank A still holds a loan, Bank A may not be as aggressive about churning its own portfolio of loans. But when you factor in the amortization schedules, closing fees, and ability to resell your loan for a quick capital infusion, there may be incentives to do so. But this represents only a small slice of the pie.
The bigger slice of the pie is the older mortgages already sold on the secondary market packaged into securities. Banks allow mortgage refinancing because they are churning the loans of thousands of anonymous, disconnected mortgage backed securities holders. They are not stealing accounts from the local lender down the street who you go the church with, or meet at the rotary club. There is no one to defend the old loan.