Mortgage
What Is Refinancing And When Would It Be Worth It?
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To refinance a housing loan is simply to replace an existing mortgage with another one from another bank.
This essentially means that the funds from the new loan would be used to fully pay off the current one. The borrower would then be making monthly payments to the new lender and say goodbye to the old one.
There are 5 main reasons why homeowners would decide on this course of action, which can sometimes be tedious.
- To reduce financing cost as the replacement loan has a lower and more attractive interest rate
- To hedge against the risk of interest and index volatility by refinancing from a floating rate loan to a fixed rate loan
- To extend the tenure of the home loan so as to reduce the monthly debt commitment
- To cashout and raise money via a home equity loan for personal or business use
- Borrower feels unfairly treated by the current lender and don’t wish to do business with them anymore
Every reason has it’s reasons that motivated a borrower to take action in refinancing to another bank.
Reduce financing costs
The most common reason for borrower to refinance their mortgages is to reduce financing costs by reducing interest rate, which ultimately leads to savings… which can be spent on family holidays…
Since all lenders basically sell the same product, which is essentially money, there really is little point in paying more than you have to on a home loan.
If your favorite instant coffee mix is selling for $1 cheaper at NTUC downstairs, surely no hard-selling would be required to convince you to at least buy a couple of packs.
In the same line of thought, it does not take a lot of convincing for a homeowner to switch banks.
While larger the difference in interest rates would be, the more money a borrower would save from refinancing, it should not be ignored that the higher the loan balance being refinanced, the higher the savings would also be in terms of dollars.
When the difference in interest rates is small, then a borrower has to calculate the break even point and assess it against his future plan in order to determine whether replacing the current housing loan with a new one makes any financial sense at all.
Hedging against volatility risks
All Singapore homes loan are either pegged to an index rate or would eventually be.
And as indices move with market performance and trends, they can sometimes be very volatile. This can sometimes be too annoying a stress that someone would be better off not having.
So refinancing a current loan which is on a floating rate to one with a fixed rate can ensure that the borrower would only have a predictable monthly payment to make during the initial period of fixed rates.
Fixed rates can stretch for as long as 5 years. After which, it would convert to an adjustable rate mortgage.
The borrower can then choose whether to repeat the whole process of refinancing again.
However, when volatility factors are what is pushing you towards refinancing, then maybe talking to your banker about a re-pricing can sometimes be good enough to convert to a fixed rate loan.
Tenure extension
The main reason why borrowers might want to extend the tenor of the loan is to reduce monthly payments so to ease their personal cash flow.
This could be a critical factor when a household is struggling financially and barely making ends meet.
However, savvier homeowners or investors could argue that when interest rates are low, it makes total logical sense to stretch the loan tenure to it’s maximum limit.
The financing cost would be cheap, resulting in low interest costs.
The reduction in cash outflow would also free up fund for more investments… maybe in more property…
Investors with an appetite for leverage would inevitably also look into cash out refinancing.
Cash out
A cash out transaction basically means a new and bigger loan replacing the current one.
The funds from the new loan would be used to pay off the existing smaller loan, and remaining balance which is called a home equity loan, would then be disbursed to the borrower to use for business or personal matters.
The borrower would then be liable for a bigger loan, which would have a higher monthly debt obligation than the old loan. The exception being that the old loan has a significantly higher monstrous interest rate compared to the new loan.
Borrowers considering cashing out should consider a HELOC as an option if the need for large funds is not immediate. HELOCs can be very suitable when needed funds do not have to be in a lump sum.
Pissed with current lender
Being angry with a bank is one of life’s certainties.
In fact, a monk once told me that if one has never felt unfairly treated by a bank on any occasion, then he has not lived a complete life.
And in all honesty, I cannot tell whether he was joking or not.
While switching lenders for emotional reasons instead of logical ones can seem ridiculous, some people can get so upset with how they have been treated by particular banks, even feeling betrayed, that they would move their loans to another lender. Even if it would cost them financially.
It’s not a savvy thing to do. But who am I to judge.
Alternatives to refinancing
Even though refinancing a mortgage would imply a better-off position for a borrower, it is not always the only option available to be “better-off”.
Loan modification
People don’t talk about loan modification lot in Singapore. But they happen more often than lenders would admit to.
Loan modifications refers to changes in the terms of the loan contract, or facility letter as a banker would put it, that satisfies a borrower enough to not move the loan to a competing bank.
The issue is that banks seldom agree to modifications unless it concerns a highly valued customer who they are not willing to lose.
Even a priority banking or premium banking customer can be given the finger if the lenders knows that he or she is trapped.
This can occur in some circumstances like:
- There are no better deals in the market to switch to
- The borrower would not be able to refinance due to a depreciation of property value or TDSR requirements
- The borrower would incur huge upfront fees to refinance with a competing lender
- etc
But do realize that we are just speculating reasons and cause & effects here.
Nobody really knows what a bank is thinking when a loan modification request has been filed.
The rule here is that if you don’t ask, you don’t know whether you would receive a favourable or unfavourable response. So just give them a call and find out.
Re-pricing
A re-pricing simply means a change in the interest rate structure, which would be assumed to result in lower interest rates. Thereby helping borrower with savings.
Sometimes in view of market movements, banks can have bank-wide instructions to treat re-price requests favourably.
This could be a strategic response to what competitors are offering and promoting.
So every customer who calls them up about re-pricing might get it easily approved.
The lesson here again, is that if you don’t ask, you would never know.
Conversion
A conversion option is a provision contained within your loan contract that when exercised, allows you to change your current loan to a new one with the same lender.
These types of terms, or clauses as some would call them, are not found in all loan agreements.
Check your facility letter. If this option is stated and still active, then you would have to the right to activate it and the lender would be obligated to change your loan to a new one with different terms.
The loan options available are usually what the lender is offering to the public at that point in time.
So if the lender is offering loan that are meant to scare away home buyers and owners, your choices are pretty much limited to them.
Loan redemption
If you are financially well off with cash in the bank, and the thought of refinancing is purely a decision based on numbers, then consider fully or partially paying off the mortgage.
A full repayment would enable you to get rid of this headache once and for all.
A partial redemption would enable you to reduce the principal balance, resulting in lesser interest costs over the years ahead.
Do be aware that lump sum payments towards the outstanding balance would only reduce the cumulative interest which you would eventually pay. You would still be on the current interest rates and the tenure remains the same.
Changes to these two variable would have to be done via re-pricing or contract modification.
Potential circumstances of refinance
If a new mortgage loan that would replace the existing one is clearly better in every way, the decision to switch would be an easy one.
However in this day and age, life has a way of giving us migraines even in the best situations.
To understand the following, you should be acquainted with index rate and fully indexed rate which includes the spread.
Index rate is lower than fixed rate but fully index rate is higher
These situations seldom occur as the economics of loans would always mean that fixed rates would be higher than fully indexed rates.
This is because the banks charge extra for the security of predictable rates.
This also means that the market, or the bank, would realize this mistake soon and make changes to it almost immediately.
A borrower would profit (via savings) from refinancing immediately to a fixed rate home loan.
The longer he waits, the more likely the bank would rectify any dependencies and expire that particular loan offer.
Fully indexed rate lower than than fixed rate but index rate is higher
As out-of-whack as it sounds, this can occur during major interest rate movements.
The fully index rate would most probably refresh to a new rate at the next adjustment interval.
This is a sign that the market is confused due to contrasting signals from world economies.
Borrowers should wait for the adjustment interval and see which direction the market is heading before taking up a refinancing offer.
Fixed rate is higher than index rate and fully indexed rate
This is the most likely scenario in a normalized industry setting.
Unless you are sure that interest rates would hike exponentially in the short and medium term, it would make absolutely no sense to refinance to a fixed rate housing loan.
In recent years, ever since the financial crisis of 2008, those who have refinanced to fixed rates have been holding onto the wrong end of the stick.
However, these borrowers would probably not mind as they willingly paid a premium for the predictability.
Fixed rate is lower than both index rate and fully indexed rate
Unless you forecast interest rates to crash in the near future, the fixed rate loan would look very attractive indeed.
Other refinancing factors to consider
While regular home owners and borrower might feel that the major deciding factor of whether to refinance, and of so, to which loan is down to interest rates, professionals in the financial industry would know otherwise.
If you want think, calculate and evaluate like a pro, then the following factors must be considered.
- How long do you expect to hold onto the new loan?
- What is the breakeven point?
- What are the advantageous features of current floating rate loans?
- What are the advantageous features of current fixed rate loans?
- Are there prepayment penalties?
- Are there cash rebates? Subsidies? Or cash back features?
- Mortgage insurance premiums and features?
- Where is the general direction of interest rates heading?
- How high is the possibility that you would be stuck with the new loan for a long time and unable to refinance again?
Do put enough thought into your decision as this can be a decision worth thousands of dollars. And for some people even millions of dollars.
Finally, take note of penalty fees on the current loan that you might incur should you decide to go ahead and refinance it.
When you are still within a lock-in period, you can sign up for a new home loan to replace a current one as early as 6 months before the expiry of the lock-in period, and the current loan would probably require a 3 month notice period in order for you to avoid interest in lieu.
This means that you can accept a new loan 6 months before the lock-in period expires, and serve notice 3 months before the expiry to avoid any of the penalties associated with full repayment.
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