Strictly speaking, refinancing provides an opportunity to fix some of the things that are wrong with your existing loan so you are better placed to reach your goals – it’s having your mortgage work for you rather than against you.
In the simplest of terms, refinancing is when you replace all or part of one loan with another. In the world of credit cards, this is commonly known as a balance transfer; however, in relation to a mortgage it is called a refinance.
There are two types of refinancing:
An internal refinance, which is where you switch mortgage products but stay with the same lender. Earlier this year, Fujitsu Consulting reported that this occurs about once every 3.5 years.
An external refinance, which is where you switch everything, including lenders; according to Fujitsu, this happens every 6.2 years or so.
You can also do a partial refinance, which is where you keep your original loan but split part of it out to another loan for increased flexibility, reduced cost or reduced risk. If you have more than one property, you can do a partial refinance using a combo of internal and external refinancing if you want.
HOW TO MAKE REFINANCING WORK FOR YOU
Rule 1 Work out what you want to achieve by refinancing
It may seem pretty obvious, but clearly identifying what you want makes it much easier to get what you want. Let’s take a quick look at some common reasons for refinancing.
Reason 1: To increase flexibility
Your existing lender has turned down your application to increase your debt. You should work out how much extra debt you actually want and whether you are 100% sure that growing your debt is such a good idea.
Easier access to equity
You find yourself needing to draw on your equity frequently and are looking for a low-fuss method, such as a line of credit. Make sure you have the discipline to keep paying off your debt with the newfound flexibility of a line of credit, otherwise this can be a very costly decision.
Interest saving options Your loan doesn’t have the right degree of interest saving features which you can and will use. These include features such as fortnightly repayments, unlimited extra payments with feefree redraw and 100% offset account.
Remember, interest savings don’t just come from thin air. You must be able to commit to making extra payments on your loan and/or use your offset account as a savings account where you park increasingly fat lumps of your hard earned cash.
Make sure you understand and list your flexibility ‘must haves’ before you start comparing different loans.
Reason 2: To reduce flexibility
As hard as it is to believe, this does happen. I’m not just writing about reducing flexibility to get a better rate, but reducing flexibility to help ensure you get debt-free sooner.
The classic example of this is to switch from a line of credit, which requires good financial discipline to work effectively for you, to a principal & interest repayment with, if it’s worth it for you, a 100% transactional offset account.
For many people, having a separate income account from the loan account actually helps them understand what they have to play with and whether they are making progress. Like increasing your flexibility, make sure you list your flexibility ‘mustn’t haves’ before you start comparing different loans.
Reason 3: To reduce risk
For most people, risk kind of sneaks up on them. When you first take out your mortgage, you are often so busy focusing on the property that you forget to cover your risk. One, two or three rate hikes can sometimes get people a little worried about whether interest rates will rise further and if so, by how much and how quickly.
However, the reality is that if rate hikes are causing you to assess your risk, it’s probably too late to do anything practical such as fixing – fixed rate loans tend to carry higher interest rates anyway. They also usually move up ahead of variable rates too. It’s a bit of the old ‘shut the gate, the horse has bolted’.
That’s not to say you shouldn’t fix your rate if you are getting worried; just make sure you shop around and understand that if rates fall once you’ve locked into a fixed loan, the price of getting out can be hideously high.
Factors that could impact on your ability to refinance
Your repayment history or changed financial circumstances – you have to be a desirable candidate for a home loan just like any other borrower
How high is your LVR? – lending criteria has been tightened; a maximum loan-to-value ratio (LVR) of 90% or lower might be required
An LVR over 80% for your new home loan could incur more lenders mortgage insurance
Is your loan size too small? – refinancing a loan amount of around $150,000 or below is likely to cost you more to exit than the savings you’ll receive by switching
Refinancing will not automatically help you save money – so is the switch worth the cost? As a rule of thumb, you must be in a better financial position within 12 to 18 months of refinancing
Reason 4: To save money
By far and away ‘To save money’ is perhaps the most common reason people refinance, yet it is also the most misunderstood. What? Yes, I hear you. Who would think that three short words could cause trouble? Actually, it’s just one word that’s the trouble maker. Save.
Once upon a time, when Australians weren’t as credit crazed as they are today, ‘To save’ meant to set money aside for a special purpose like education, a holiday or a new car. Of course that was back when television was black and white and a mobile was a wire, string and wood contraption that hung from the ceiling. Nowadays ‘To save’ has a number of completely different meanings.
When it comes to mortgages, the most straightforward meaning of ‘To save’ is that you will avoid interest and fees, doling out less money to the lender on the same loan over the remaining term of your loan. You know, stay where you are and you will pay $515,000 in interest and fees over the rest of the loan or switch to a new loan and pay only $500,000. That’s a saving of $15,000.
To keep this as simple as possible, let’s call this the total saving.
Interest & fees remaining (your loan) – interest & fees (new loan) = total saving
The second and somewhat more confusing version of ‘To save’ involves refinancing to lower your minimum repayment. You can usually spot these types of ‘savings’ because they only ever mention the repayment. They typically go something like ‘stay where you are now and pay $2,500 a month or switch to a new loan and only pay $2,200 a month. That’s a saving of $300 a month!’
The problem is that claims of a ‘repayment saving’ only deliver half of the truth. No matter how counter-intuitive it may be, a lower repayment does not always result in a total saving. In fact, reducing your repayments can and often does result in a total loss which means it isn’t a repayment saving at all, because you wind up repaying more in the end.
To understand this a little better, let’s jump back to the world of credit cards. Many of today’s credit cards cost you no interest if you clear the full balance each month. The flipside to this is that they charge you immense interest if you pay one cent less than the full balance. Let’s think about a credit card balance of $2,000 offering a minimum repayment of $50 and simply look at the choice between these two payments.
Make a monthly repayment of $2,000 and pay no interest, or;
Make a monthly repayment of $50 and pay immense interest.
It should be pretty obvious that in this situation you can reduce your monthly repayment by $1,950 (which is a very impressive half truth) or you can avoid paying interest altogether which is the only way to get any kind of total saving. This means that you have reduced your monthly repayment, but have increased the interest you pay from nil to immense. That means that you wind up repaying more, so let’s bar the idea of a repayment saving and talk about it simply as
The main ways lenders and mortgage brokers alike create lower repayments are to find a new loan that meets your needs and one or all of the following:
Has a lower interest rate. Good, provided it doesn’t later step up to a higher interest rate.
Has less ongoing fees and charges. Good, because you pay less fees
Sets up your new loan as interest-only. Possibly bad, because by taking the lower repayment you wind up paying immense interest.
Restart your loan over a longer term (reamortising). Possibly bad, because by taking the lower repayment, you reset the repayment clock back to zero and wind up paying immense interest.
While there is no problem with switching to interest-only or reamortising your loan (more on this in a moment), it is important that you understand the cost of these decisions fully. It is also important to understand that you can probably do both of these things with your existing lender, which means the new loan really needs a much better interest rate and fee structure if you are going to make a total saving.
Rule 2 - Apple with apple
It is always important when you are making comparisons between different loan products to make the comparison apple with apple - compare home loans. I seem to confuse some people when I write about apple with apple as they think that I mean you can only compare a basic with a basic, one fixed rate with another and so on. That’s not what I mean. You can compare any type of loan with any type of loan. That doesn’t matter a jot.
Apple with apple means that the numbers that affect the cost of each different option are the same. That is to say that the loan term is the same, the same repayment and rate of repayment, the base loan amount is the same for all and that you’ve got all the bibs and bobs for each option.
Although it may sound obvious, consumers often lose sight of the fact that if you are five years into paying your 25-year loan, you only have 20 years to go; the repayments on your loan are based on your original loan term, the original loan amount and factoring in the current interest rate.
Becoming confused around this when you are considering a refinance will be costly so this is an important concept to understand.
Without getting too mathy, let’s assume the original loan amount was $350,000 and the current interest rate is 6.50% pa Use any old repayment calculator and you should discover that your monthly repayment is around $2,363 a month.
Even though you have had the loan for five years, you are still paying the $2,363 a month, yet you have only 20 years of repayments to go (did I say only?). Although your loan balance has reduced through five years of repayments, so too has the time left to pay it off which is why your minimum repayment is unchanged.
Go back to that repayment calculator and plug in the same information, only changing the loan term to 20 years which is the remaining term of your loan. You also need to change the loan amount to $316,967.60, which is what your current loan balance would be after five years of making the minimum repayments. The result? The repayment calculator should be telling you the repayment is $2,363 give or take a few cents.
Congratulations, you have just done an apple with apple comparison on two identical loans. As you would expect, the results are the same.
So, instead of talking about your current loan in the original terms: “…it was $350,000 when we took it out and I think the term was 25 years…”, think about your mortgage in its true current terms.
For our sample loan, that’s a loan amount of $316,967 with a loan term of 20 years.
Now, let’s go back to the repayment calculator again. Leave the loan amount at the current loan balance of $316,967.60; however, change the loan term from 20 years to 25.
The result should be that your loan repayment drops from $2,363 to $2,140 – or as a shyster might try to convince you, a saving of $223 a month! What you really have done is reamortised the loan which is jargon for changing the amount of time you take to repay the loan.
The question is, how much more (in the long run) does it cost you to lower your repayment by that $223 a month? Well, let’s get out the calculator again to work out the cost. The first thing to do is work out the total repayment for your current loan – the 20-year option.
Total repayment (now)
= number of repayments
x minimum repayments
= 240 x $2,363
Then the cost of reamortising your loan
to 25 years:
Total repayment (new)
= number of repayments
x minimum repayments
= 300 x $2,140
Then simply work out the difference:
Cost = total repayment (new)
– total repayment (now)
= $642,057 – $567,120
That’s right, you lower your repayments by $223 a month by paying an extra $74,881.80 in interest (let’s call it $75,000 shall we?). Now if you really need to lower your repayments to fulfil a life/lifestyle critical need and are willing to cop the expense, then fair enough. However, most people aren’t – they just do it without realising the full impact.
Enter the shyster
Shysters show you a loan with a lower interest rate, say 0.25% lower, which doesn’t sound like much, but it is – it’s just not as much as the shyster will have you believe.
When shysters do their comparisons, they work out your repayments on the new, lower interest rate with a new, commonly accepted loan term of, say, 25 years. After all, you took out a 25-year loan yourself, right?
So let’s just go back to that repayment calculator one more time and use the shyster strategy. Leave the loan amount at $316,967.60. Leave the loan term at 25 years and reduce the interest rate from 6.50% to 6.25% and you should see your repayment magically drop from your current $2,363 down to just $2,091.
If the shyster convinces you that you are saving almost $300 a month because of the lower rate, you’re being conned. The lower repayment comes from reamortisation of your mortgage and costs you an extra $60,000 in interest. Yikes!
However, when compared apple with apple over a 20-year term and forgetting about the actual cost of refinancing which will reduce the savings, the 0.25% lower interest rate produces a repayment of $2,317 and interest savings of a little over $11,000 across the 20 years. Spend a couple of thousand dollars switching and those savings rapidly begin to evaporate.
Same repayment and monthly repayments
No matter how often you actually repay your loan, you are much better off comparing on the basis of monthly payments. This is the simplest way to stay apple with apple as the moment you start talking about fortnightly or weekly repayments you allow confusion into the comparison process.
For example, when you are being quoted a fortnightly payment, are you being quoted about a fortnightly payment as in half of the monthly payment, or the repayment based on 26 repayments every year? Regardless of whether you understand the difference between these ‘fortnightly’ payments, you should be able to see there is room for confusion. Where confusion can creep in, so too can costly errors. Keep it simple, compare on monthly payments and then once the loan is settled, pay on whatever basis works for you.
Which brings us to the next question – which repayment frequency should you use? If you are like most Australians, then the answer is to use the minimum monthly repayment, because sadly, most of us only ever pay the minimum required repayment. However, if you overpay your mortgage, you should ignore the minimum monthly repayment and compare the cost of each option based on your repayment amount.
All the bibs and bobs
Refinancing costs time and money. The question is how much time, how much money?
Make sure when you get down to crunching the numbers that all new lender scenarios include:
Deferred establishment fees or any penalties your current lender will charge you when you leave.
Loan discharge costs your lender charges you for co-ordinating the documentation required to inalise your loan.
Both mortgage discharge and mortgage registration costs charged by your state or territory overnment for switching the lenders noted on your title documents.
Any loan establishment costs of the new loan including:
Lenders mortgage insurance
TIP! Don’t ignore the power of incumbency. It always costs money to refinance to a different lender. If you only have a mortgage on one property, these costs (assuming there are no lender penalties) are still going to be between $500 and $1,000 once you add up loan discharge costs and government charges to switch the mortgage from one lender to another. This gives staying with your current lender a powerful edge when it comes to saving money.
Rule 3 - Give your lender a go
Don’t think of your lender as a person. It’s not, it’s a business. They don’t emotionalise their decisions about whether they will help you or not and neither should you.
Rule 4 - Beware the pen alties
Earlier this year, two gents from Melbourne University released a white paper on early exit penalties. It’s a hard and heavy read which basically says, buyer beware. Since taking over national credit regulation from 1 July this year, the Australian Securities & Investments Commission (ASIC) has decided it should take a closer look at exit fees which are used by lenders to keep careless borrowers locked into an underperforming mortgage or gouge them on the way out.
Despite the recent concern in these fees from ASIC, they will never make an appearance in the comparison rate. If you are looking at them in your loan contract, it’s probably already too late so make sure you ask about them and get a written quote on all of the exit fees of your new loans before you apply. Remember too that lenders have different names for them so make sure all exit costs are included.
As a guide, you shouldn’t ever be paying more than $1,000 regardless of whether you decided to refinance the loan in the first year, fifth year or you are making your final loan repayment at the end of year 30.
Anything larger than that and you will probably find it hard to refinance without going backwards financially for the next three or so years. If your lender wants you to reach into your pocket any deeper than $1,000, you want to be very sure that the deal you are getting is a great one; that the loan will grow with your needs until the penalties wear out and that you feel confident that your lender isn’t about to jack the rate up one month after you sign the contract.
Of course the only way to be sure on that last point is to take a fixed rate. So if you are taking variable, make sure you pay close attention to the exit fees to ensure you don’t get stuck with a lemon.
Rule 5 - Less time = more risk
By now you should be getting the feeling that you need to be just as careful refinancing as you were when you first arranged the mortgage you’re now thinking about leaving. No doubt that’s true. In fact, you should be more careful because you might have picked up some disinformation that could cost you dearly.
In most cases, the beauty of a refinance is that unlike when you purchased your property, there is no deadline to get your next, seriously large financial decision right. The more time you put into making sure your next move has the features you want and then crunching the numbers apple with apple, the better your outcome will be.
If you don’t have the confidence to crunch the numbers, speak with your accountant or a borrower’s agent to get the right advice to protect your interest.