In a recently published research paper, three professors from the University of Chicago and Brigham Young University asked a provocative question: Should consumer-borrowers be forced to refinance their mortgages when it is in their best financial interest to do so?
After studying a random sample of 1.5 million residential mortgages that were outstanding in December 2010, the professors found that 20% of the loans that would have significantly benefited from refinancing at then-prevailing lower rates remained in place. They speculated that some consumers failed to take advantage of that option because they were unfamiliar with the process. Others may have been dissuaded by the typical upfront fees for refinancing, and still more may have been unimpressed by savings that seemed modest on a per-month basis instead of considering the greater value over the life of the loan.
The three academics tested their thesis by partnering with a nonprofit that specialized in helping low-income consumers with their finances. The organization snail-mailed 446 letters offering reduced-rate refinancing to those with existing higher-priced mortgages. The vast majority of the recipients didn’t bother to respond.
A Similar Problem
As I read through the paper, I thought about the student loan crisis—in particular, how the U.S. Department of Education laments the fact that only a small percentage of borrowers who would benefit from the relief programs that were put into place had taken advantage of them.
What the DOE fails to recognize or acknowledge—and the authors of the research paper as well—is the role that loan-servicing intermediaries play in this regard.
These companies are compensated by—and therefore beholden to—the entities that own the loans, whether originating lenders or investors to whom the loans were sold after the fact. Technically speaking, loans that are refinanced aren’t modified in place. They’re paid off and replaced by new loans. More to the point, the old loans are exchanged for new ones that carry lower rates.
In other words, even if a soon-to-be-terminated note holder were to refinance the existing loan for its own account, it would be trading down to a lower-yielding investment. How would you feel about giving up an investment that yields, say, 5% for a like-kind opportunity that returns 3.5%?
So it’s not surprising that refinancing offers are only begrudgingly touted—if at all—which brings me back to my initial thought. What if in one fell swoop, all outstanding government-backed student loans were automatically refinanced at prevailing rates without regard for origination channel or current payment status (limitations that currently exist under the fed’s relief programs)?
Two questions immediately come to mind: Where would the government get the kind of money it would need to do such a thing, and why should borrowers who have no problem making their payments be given that kind of gift?
The first question is easy. The government is already financing the loans it has made—at a substantial profit, as it turns out. That’s because they’re playing the yield curve. In plain English: the government is charging student borrowers rates that are indexed to higher-rate, longer-term Treasury notes, funding those same loans by selling lower-rate, shorter-term Treasury notes, and pocketing the difference.
The government can continue this potentially dangerous gambit—after all, rates can only go up at this point—and book the gains for as long as they last. Or it can refinance its entire portfolio in a more prudent and sustainable fashion (such as by targeting the 5-year half-life of these typically 10-year loans) when it implements the global refinancing of these debts.
The net cost to the taxpayers? Zero, because this initiative would not require any incremental borrowing and also because the pricing scheme put into place in 2013 will continue to assure a profitable outcome.
As for the second question—just as it always has been in the case of residential mortgages—those who have the financial wherewithal to qualify for a new loan at a lower rate will do so, even though they are perfectly capable of continuing to make the payments as they are. Why shouldn’t student borrowers have the same opportunity?
An Easier Way
Incidentally, we’re really not talking about loan refinancing per se, which typically involves a brand-new contract with a brand-new lender. Rather, what I’m describing is something called loan recasting, where the existing debt is reconstituted by the current note holder so that it remains in its portfolio of loans. The process is quicker, cheaper and, therefore, more efficient for all concerned.
Any offer to recast debts should also incorporate three options: Borrowers can choose to use the lower interest rate to reduce their remaining payments, continue remitting the current payment amount and shorten the term, or take the lower rate and extend the duration.
That third option would replicate the relief programs the government has been embarrassingly unsuccessful at promoting. Even better, this would cost taxpayers less than what it does now, especially when you consider the vast sums the feds continue to spend on collecting past-due loans that should have been restructured this way long ago.
This story is an Op/Ed contribution to Credit.com and does not necessarily represent the views of the company or its affiliates.
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