Evaluating Risks

Evaluating the risks involved with home refinances

While it is evident that refinancing the home brings with it a lot of benefits, it should also be remembered that even though the idea of taking another loan on the house looks rosy, it does bring with it its own set of risks involved, which all need to be considered before making a decision and applying for this option. One of the major hidden risks is involving the same collateral for a lot of different loans. Also the fact that if the mortgage is not completely paid off and if there is a higher interest rate involved then the monthly installment amounts will go up. Care should be taken that the inflow of money is enough to ensure that the extra expenses are covered and you should aim at a realistic budget, whereby you can ensure that the payments are cleared on time. If possible, you can cancel or at least stop the usage of the credit cards which with their low limits and non-direct spending nature result in spending which are beyond the anticipated limits and hence cause additional debts, which will be hard to clear.

The other factor that you should avoid here are the high loan to value ratios. If this cannot be avoided or if you are considering taking cash out when refinancing then you should also consider yourself in a position where you would be required to pay mortgage insurance, which is commonly referred to as PMI. The PMI is needed in all cases where the owner’s down payment is less than 20 percent of the equity in the home. Needless to say, the PMI brings with itself the costs associated with it which increase the monthly installment amounts. The high loan to value also brings with another risk of loss if you try to sell your home in the future. Thus if you take more than 80 percent the money out of your property, then you are moving it directly to the risks of market fluctuations, whereby if the market value of the property goes down, you may end up owing more debt to the lender than the actual cost of the home. For example, you had purchased your home for $50,000.00 in the year 1999 and then you had refinanced it with 95% cash out, on a $100,000 appraisal, in the year 2009. Hence your home loan value would be about $95,000 but if you plan to sell your house in the year 2011, and the prices for houses at that are $85,000, which is about $10,000 less than what had owed on the mortgage. Thus you are in a situation where you would owe more than what your home is worth.

If you select an interest only policy of refinancing, then you are liable to another risk, which is the risk that the monthly payments to be made for the interest only and fully amortized loans are almost similar to each other. However, having one or the other option can make a major difference in your future finances. Hence, it makes good sense that if you are opting for a interest only policy, do make sure that you understand all the terms and conditions of the policy and make due diligence before finalizing on the selection. The best thing to do would be to try and select a refinance option where you can choose a loan with an additional principal payment monthly or annual payment, so that you are at least contributing some amount towards the principal amount. Some of the lowest payments possible are available with the interest only loan of the 40 or 50 year loans. This is one of the best ways to ensure that some payment is being made towards the principal amount.

One other risk which is not evident at first, but which really needs to be considered is the prepayment penalty. Now when lenders lend the money to the debtors, it is done with an idea that the debtor will pay back in a large number of installments over many years, and hence this gives the lenders a chance to earn the money. However, what sometimes happens is that the debtor arranges the money from some source and tries to pay off the whole loan in the first few years. Obviously, this will lead to the lenders losing out on their profit and hence, the lenders have been given this authority of prepayment penalty. This option can be exercised by the lender if the debtor tries to make a single payment which is more than 20% of the remaining principle balance. Let us consider an example to understand how the lender loses the money and how a prepayment clause can be activated. Say you took a 30 year mortgage refinance policy for 100,000 dollars, but somehow repaid the amount in just 3 years. This will result in the lender losing out on 27 years of his interest amount. Thus they have a payment which is used to offset this loss of profit. The rate used most widely is 1% of the principal balance, which gets charged in the first three years. That is, if you pay back the 100,000 dollars in 3 years, you need to give the bank an additional 1000 dollars (1 percent of 100,000 dollars) as the prepayment penalty. However, you need to check the terms and conditions of your contract since the term of the prepayment penalty phase and the percent of penalty are both different in different policies. Before making the decision you need to see if the loan is very small, then the gains from these refinancing would outweigh the risks, and if it is big the amount to be paid as a penalty may cancel off the benefits of the refinancing. Theoretically, it is suggested that you should not get a refinance within the prepayment penalty phase, in case you have a 5% prepayment penalty. It is best to deal with such cases by comparing the proposed situation with the current one and consider if you are able to meet the requirements of the mortgage loan, in spite of paying the penalty. Nevertheless, it should be kept in mind that this penalty amount is mentioned in loan closing deal and hence even if you change your lender, you would not be able to get rid of this penalty until the penalty phase is not over.

Properly understanding the situations and weighing the above risks can provide more understanding regarding what to expect from the refinancing options and hence make the debtors aware of what they are getting into before they agree to the terms and conditions of the new policy, if they do decide to take one.

Updated: Jan 7, 2011 10:09