When interest rates are low it’s natural for borrowers to consider refinance options. Interest rates in Australia are now at record lows and so many lenders are encouraging borrowers to refinance their existing mortgages to gain market share.
But the intelligent borrower knows that cost savings are often over exaggerated when refinancing and a refi which increases your debt is unwise if the value of your security assets fall or if you have insufficient cash flows.
If you’re considering a refinance this post will enable you to take a more educated approach.
We will discuss the two most common reasons people refinance in detail:
1) To secure a better interest rate; and
2) To access equity in their properties (enabling them to pursue new investments like shares or additional investment properties)
Mortgage refi #1 – to secure a better interest rate
Since interest rates started falling in November 2011 the cost of borrowing in Australia has become increasingly cheaper. In May 2015 the Reserve Bank cut the official interest rate to a historic low of 2.0% and we are now in a situation where the cost of borrowing is cheaper than it ever has been before.
In the current environment many existing Australian borrowers find themselves paying higher interest rates than what’s currently being offered elsewhere in the marketplace. Either they fixed their interest rate when rates were previously higher or perhaps they did not get a competitive variable rate offer when the mortgage was originally established.
Refinancing an existing loan to take advantage of new/lower rates is the number one reason borrowers make this decision.
The opportunity to refinance is available to Australian borrowers because house prices in most areas have experienced strong levels of growth. Borrowers therefore have sufficient equity in their properties to refinance, and so it then becomes a relatively straightforward process – simply paying off your loan from bank A with your new loan from bank B, and then enjoying the new lower repayment requirements from bank B.
But there are a few things to watch out for.
Firstly, your lower repayments are going to look cheaper than they really are, because when you refinance you typically reset your loan period and this gives the appearance of greater savings.
Consider this example:
On a $400,000 30yr loan with 5.0% interest, the monthly repayments are $2,150 and the total interest payable over the life of the loan is $373,000. After 15yrs you would have paid $258,048 in interest (only $114,975 interest remaining) and your principal loan balance would have been reduced from $400,000 down to $271,500.
If you were to refinance this $271,500 balance at a much cheaper interest rate of say 4.0%, then your monthly repayments would be reduced to $1,296 (from $2,150 previously, so nearly less than half) however you would have to make them for another 30yrs and this would cost a total of $195,126 in interest over the life of the new loan.
Remember you previously only had 15yrs remaining and a further interest obligation of $114,975. So on the one hand your monthly repayments have been lowered but on the other hand your interest obligation has increased and you will be making interest payments for longer.
The true cost savings of a refinance can be seen if the original loan was refinanced to a new loan with an equivalent term outstanding.
Using the above example if the $271,500 loan at 5.0% with 15yrs remaining was refinanced with a new $271,500 loan at 4.0%, also with 15yrs remaining, then the monthly repayments come down to $2,008 and the new total interest payable is $89,985. The monthly repayments don’t look as cheap as with the 30yr loan (where the interest repayments were spread out over a longer period of time) however your total interest payable is now $195,126 – $89,985 = $105,141 less. Also in comparison to your original position at 5.0% where you owed $114,975 you’re now $114,975 – $89,985 = $24,990 better off… take away any refinancing or brokerage costs and now that’s a real saving!
Here’s a recap:
The moral of the story is that if you extend your loan term on a refinance your apparent savings will look better (in the form of lower monthly repayments) than they actually are.
Unfortunately many banks and brokers won’t explain this to you properly because a) it’s not straightforward; and b) the longer your loan term the more they get paid.
If your goal is to pay down your principal and reduce debt then look to refinance with a new loan term that matches whatever term was previously outstanding on your original loan.
If however your personal situation is aided by having larger interest repayment obligations (there often tax advantages for high income earners) then the longer loan term may still be preferable.
Mortgage refi #2 – to release equity and buy additional assets
In the previous Soldier Tom post we explained that once your loan is paid off and/or you build enough equity in your property then you can pursue new investment opportunities to grow your wealth (you can read the post here). This was our introduction to the theory of wealth building.
Here’s a more practical example of how it can be applied in the real world.
Equity release to buy investment property (no capital contribution)
The attraction of refinancing to release equity (e.g. cash) from your property is that you can use the surplus proceeds to buy other things, a second property for example.
The more equity you have in your first property, the more options you have. If you have enough equity it’s possible to purchase your second property with no additional capital.
Sound interesting? Here’s how it works…
Say the value of your current home is $650,000 however your mortgage is only $375,000, leaving an equity balance of $275,000.
Strategy Part 1: A wealth building strategy might involve refinancing your existing $375,000 mortgage at say 80% LVR, with a new mortgage of $520,000 (80% x $650,000).
You would use the new mortgage proceeds to pay down your existing mortgage of $375,000, leaving you with equity/cash-out of $145,000 to pursue your new purchase.
Strategy Part 2: Find an attractive investment property which costs $300,000 (purchase price), plus $20,000 (additional costs), plus $5,000 (cash reserve) = $325,000 total. You could take out a second mortgage on this investment property for $180,000 (60% LVR x $300,000).
Result: Your $145,000 from Part 1 plus your $180,000 from Part 2 = $325,000.
This is the total required to purchase the investment property.
So by refinancing and taking out a second loan you have covered all the costs associated with buying your investment property.
Your new (combined) interest payments are higher however you now have two real estate assets and you haven’t had to contribute any new capital of your own.
So long as you have the cash-flow to support both loans this could be a powerful strategy to grow wealth. Of course if property prices were to fall it could also work against you, so consider this carefully before diving in.
Note that 80% LVR is generally the minimum threshold for you to avoid paying Lenders Mortgage Insurance. In a situation like this (multiple loans and securities) what’s relevant is your aggregate LVR (e.g. your combined lending on both loans $520k + $180k = $700k / your combined asset value across the two properties $650k + $300k = $950k, therefore aggregate LVR = 74%), so keep this below 80% to avoid paying the premium.
Lastly, some borrowers see refinancing as an opportunity to switch products or loan providers, or even to consolidate debt. We’ll leave details here for another time but if you have specific questions on either topic feel free to ask them in the comments section below.
Are there any other catches to be aware of?
Yes there are, however they’re not necessarily deal breakers.
Here’s what to look out for:
Fees
Additional fees may include exit and termination fees from the bank you’re leaving (these could be high if you’re ending a fixed rate loan before expiry) and application and valuation fees to the new lender.
Credit profile
During your application process with the new lender your credit report will be obtained and any signs of poor credit may result you being penalised in the form of higher interest rates or charges on your new loan. Also be mindful that every new application for credit is recorded on your credit file and too many applications in a short space of time could damage your profile.
Lenders Mortgage Insurance
Regardless of whether or not you’ve paid LMI on your first loan, if your LVR is higher than 80% on your new loan (or your new combined lending) you will be required to pay LMI again. LMI can be expensive so this cost may significantly impact your net savings.
Conclusion
Whatever your motivations are for refinancing it’s not as straightforward as simply benefiting from a lower interest rate.
Do you yourself a favour by properly understanding the advantages and disadvantages of refinancing. If you’re well informed and you’re comfortable with the risks then you will be well ahead of many others.
For the benefit of other readers could anyone share a negative experience they may have had with refinancing?
