Still Time to Refinance?

Discussion of the current environment of mortgage rates and whether or when to refinance is a very frequent agenda item for our recent conversations with clients. Long-time readers of our Wealth Management Commentary know that it is also a frequent subject in these pages. In July 2002 we made our case for interest-only mortgages and argued the advantages of variable rate mortgages over fixed rate mortgages for clients willing and able to accept the risk. The April 2003 edition addressed the fact that variable rate mortgages still made sense even in light of expectations at that time of rising interest rates. Clients who took this advice (adopting interest only and adjustable rate mortgages) benefited greatly. Today, two to three years later, the short-term interest rate environment has changed much and many clients wonder if our thinking has changed as well.

For years, we have argued the merits of interest-only mortgages for our clients. To sum up the April 2002 article, as long as the after-tax cost of borrowing is less than the expected after-tax rate of return on portfolio investment, it makes sense to borrow (have a mortgage) and not pay it back (i.e. an interest-only mortgage). Even in the current environment of rising interest rates and lower investment return expectations, mortgage proceeds still provide very cheap investment leverage (2.5 to 3% after-tax interest costs versus high probability after-tax return expectations at or above 4.5%). Our thinking here remains unchanged.

What has Changed?

There have been several recent developments in the mortgage landscape that warrant attention. The first one is the shrinking additional charge (margin) over the base interest rate on 1-month LIBOR (London Inter-bank Offered Rate) loans. The second is the narrowing of the gap between fully adjustable variable rate mortgages and the hybrid variable, specifically the 5-year fixed rate mortgage (which converts into an adjustable mortgage after 5 years).

Lower Margins on 1-month LIBOR

While over the last few years we have seen margins in the 1.2% - 1.6% range, the best we’ve recently seen is a 1-month LIBOR loan margin of 0.85%. This means that by obtaining this loan today, you can generally lower your interest payments by 35-75 basis points (0.35-0.75%). Depending on the cost of moving to this new loan, it makes sense for many clients to get the new rate even if they already have an adjustable mortgage tied to the 1-month LIBOR.

There are two ways that this lower rate can be obtained. The preferable method is through modification of an existing loan. Loan modification, unlike a refinance, does not involve paying down the old loan and starting a new loan. It is simply a modification of the old loan terms. Modifications are significantly cheaper than refinances (generally about $1,000, versus $3,000 - $4,000 for a refinance), but unfortunately are only available if the bank has not sold the original loan. Fortunately, 1-month LIBOR loans are the ones that are most likely to still be “in house”. If it’s available, this is a no-brainer! The $1,000 cost is recouped by the reduced interest on a $1.1 million loan in at most 3 months.

If modification is not available, refinancing is your other option. While more expensive (about $3,800 for a $1.1 million mortgage assuming no prepayment penalties), refinancing can quickly pay off, given current margins. For example, if you were lucky enough to obtain a 1-month LIBOR loan with a 1.2% margin in the past, you could cover the refinancing costs within one year of refinancing to a 0.85% margin. Then, the savings continue to compound. If you are picking up more than a 0.35% margin reduction, the breakeven is quicker, and the savings are even greater.

Unfortunately when refinancing, your current mortgage may be subject to those pesky prepayment penalties. Prepayment penalties on 1-month LIBOR product that we researched (and which many of our clients have) are 1% of loan value for the first four years. However, the terms of these contracts typically permit you to pay down up to 20% of loan principal in any given year without penalty, so the effective penalty is 0.80% ($8,800 on a $1.1 million mortgage). This makes the decision to refinance a little muddy. However, even in a worst case (only a 35 basis points advantage), you can recover this cost plus refinance costs in under 3 ½ years. If you are reasonably confident of your holding the new loan longer than 3 ½ years, a refinance makes perfect sense.

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