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Jack M. Guttentag The Mortgage Professor

Jack M. Guttentag, The Mortgage Professor

Should Lenders Be Responsible for a 'Tangible Net Benefit'?

by Jack M. Guttentag

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Excellent (21 Ratings)
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Posted on Tuesday, November 13, 2007, 12:00AM
"I understand that in pending federal legislation aimed at predatory lending, lenders will be prohibited from refinancing a mortgage unless there is a 'tangible net benefit' to the borrower. Is this a good rule?"

The tangible net benefit rule applied to loans being refinanced would make lenders responsible for something over which they have little or no control.

Virtually all refinanced mortgages provide tangible benefits -- otherwise borrowers wouldn't do them. A borrower who closes a refinance only to find that there is no benefit has three days to rescind. Even predatory lenders, who are the focus of the proposed legislation, provide a benefit to the refinancing borrower.

The problem is that, in exchange for the benefit, the predator extracts a pound of flesh. That's why the proposed legislation requires a "net" benefit, meaning that the benefit outweighs the cost. Unfortunately, there is no way that a lender can determine this. Whether or not the benefit outweighs the cost in any particular case depends heavily on what is in the borrower's head.

This will become clear from looking at the four main reasons that borrowers refinance: to reduce costs, raise cash, reduce monthly payments, and reduce interest-rate risk.

The Tangible Net Benefit in a Cost-Reduction Refinance

A cost-reduction refinance is one in which the new interest rate or mortgage insurance premium is lower than the existing one. In most cases, however, the borrower incurs costs upfront. If there is to be a net benefit, therefore, the future savings must outweigh the upfront costs.

But future savings depend, among other things, on how long the borrower expects to have the mortgage. This critical piece of information, if it is anywhere, is in the borrower's head.

The Tangible Net Benefit in a Cash-Out Refinance

Some of the worst market abuses arise on "cash-out" refinances, where the motive is to raise cash. Suppose that in raising $5,000 this way, John Doe has to accept a 7 percent loan as replacement for his current 6 percent loan, and $5,000 in refinance costs that are tacked on to his loan balance. The tangible benefit of $5,000 in cash is clear, but is it a net benefit?

There is no objective way for the lender to answer the question. The price seems high, but maybe the borrower needs the $5,000 to pay for life-saving medicine for his children? Again, the answer is in the head of the borrower.

It could be argued that whether or not there is a net benefit also should depend on the borrower's options. If the borrower could raise the $5,000 elsewhere at a much lower cost, the finding should be that there is no net benefit. It is neither feasible nor fair, however, to make lenders responsible for assessing their customers' options.

The Tangible Net Benefit in a Payment-Reduction Refinance

Some borrowers are willing to pay a stiff price, in the form of wealth reduction in the future, in order to reduce their monthly payments now. Frequently this involves converting a fixed-rate loan into an adjustable loan carrying a lower rate, often with an interest-only option, for a limited period. Costs are usually tacked on to the balance.

Whether there is a net benefit depends in good part on how critical it is to the borrower to lower the payment. Perhaps the alternative to a payment reduction is default. Only the borrower knows.

The Tangible Net Benefit in a Risk-Reduction Refinance

When interest rates are expected to rise, as was the case during much of 2005, many holders of adjustable-rate mortgages consider converting them to fixed-rate mortgages. The borrowers making the switch are willing to pay a higher rate now in exchange for future rate certainty. On this issue, lenders are in no position to substitute their judgment for the borrower's.

In sum, regardless of why borrowers refinance, the question of whether they receive a net benefit from it is for borrowers alone to answer. Lenders do not have the information needed to second-guess them.

On the other hand, borrowers often make their decisions on the basis of incomplete and sometimes misleading information. Instead of requiring lenders to assume responsibility for borrowers' decisions, let's make them responsible for providing borrowers with the information they need to make their own decisions.

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7 Comments

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  • Yahoo! Finance User - Saturday, December 29, 2007, 2:03AM ET  Report Abuse

    • Overall: 1/5

    I am not a mortgage holder, but what you say does not make sense - that is the reason for so few comments - there are people really suffeing out there and you are grtting paid for writing this??????????????? Sounds like CNN!!!

  • Yahoo! Finance User - Tuesday, December 11, 2007, 9:46AM ET  Report Abuse

    • Overall: 3/5

    Everyone is forgetting that people may have walked in to someone’s office to get the loans, but it was the loan officers, underwriters and banks that approved the loan. They made the programs and changed the rules on borrowing. No one twisted their arm to do this. They could have been like other banks and honest brokers. But no, they and investors (flippers) worked hand in hand to put people into these different exotic loans. To make a profit (nothing wrong with that… right!), but now the same people who made money in the market and are still sitting on depressed homes are complaining. That’s business, plain and simple. It started with the broker who seen and made his own judgment on approving and putting the loan though in the first place. Could some of the people put the numbers together, of course? But it is the responsibility of the underwriter to check things out. They did run the credit checks and seen someone who is a cashier at Wal-Mart get a loan for 300k or told them to put down something else on the loan application. What about the brokers who force or assisted in the appraisals. Let’s also remember that the broker/loan officer could have put the person or family into a better loan but talked the people into a different loan only to increase his/her pockets. Let’s also remember what subprime is. It is not only for people with so so credit but also used by investors who have money and who purchased multiple homes. Which now sit empty? But let’s really remember those borrowers no matter how bad there credit support business and the economy. No matter what happens in the next few years their will be winners and losers, in a good or bad market place. To push the blame on some family that wanted and needed the American dream is wrong, to those that looked at the dollars that is the price of expecting big profits. Some will win big others will lose big….. That means that everyone has a part in this and the only answer is not the rate freeze, it helps no one, just delays what will happen later. Will foreclosures happen? Of course, nothing will stop that. But the biggest picture is who will buy these homes, who will buy the homes of sellers who buy homes. If credit standards are now raised and people who maintain their homes who purchased in 04-06 and only primary borrowers with perfect credit buy homes or investors (picking up homes now) who will buy them in the near future? Remember the economic circle, what was new becomes old and it grows outward before coming back in. any home that the current homeowner or investor loses will become empty adding to the empty homes already on the market. So cut the blame! Let’s get to work on correcting this and developing solutions in place to hopefully avoid this happening again. Or limit some of the causes….

  • Yahoo! Finance User - Sunday, November 18, 2007, 8:45PM ET  Report Abuse

    • Overall: 4/5

    I don't care what they do, so long as I, as a taxpayer or as a holder of the increasingly worthless US dollar, don't have to help pay for it. Of course, the chances of that are slim, so I suppose it would be a good idea to impose some sort of common-sense regulation on the mortgage lenders. Making the lenders responsible for their own irresponsible lending practices is also not a bad idea.

  • jamesrwible - Saturday, November 17, 2007, 7:51AM ET  Report Abuse

    • Overall: 5/5

    This is the first time I have read an article here that has made sence. Well done! If the rest of the media would take this approach, we might pull out of this mess!

  • roman_shulman - Saturday, November 17, 2007, 12:13AM ET  Report Abuse

    • Overall: 5/5

    Well done. This is just another case where our government wants to decide what's good or bad for us. Isn't it time for us as individuals to make our decisions, or have we gotten to the point where we simply refuse to think for ourselves? Roman Shulman, Superior Funding Corporation, www.sfcorp.net.

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