Why would my current lender encourage me to refinance for a lower rate?
I recently came across a question by a neighbor who wondered about the motive of their current lender in encouraging them to refinance their mortgage for a lower interest rate:
My current lender is sending me a lot of communications to refinance with a lower rate.
I’m trying to determine why my current lender would try to reduce the interest rate. If it’s someone else, I can understand: they are trying to earn new business. But I’m not able to figure out what’s there for current lender—apart from usual fees etc.
What’s the catch here? What does the lender gain by refinancing my existing loan with lower interest rate?
This is a legitimate question. On the first look there seems to be something fishy going on here. Why would a lender willingly accept reduced interest payments on the mortgage note they hold?
Before we try to answer the question, let’s keep in mind what happens during the lifecycle of any normal mortgage loan.
- The loan is originated. Money is lent and the borrower gets the capital to pay for their real estate purchase. The paperwork starting from the application all the way to closing of the loan is taken care of by the origination department, be it a mortgage company, a bank, a credit union, etc. They get paid for this service along with other service providers in the process like the title company, the county registrar and so on. Often these expenses are passed on to the borrower in the form of closing costs. Sometimes the lender absorbs these costs in return for a slightly higher interest rate than what it could have been.
- Once the origination is complete, the mortgage can be sold in what is termed secondary market where these transactions are unseen by the borrower. The secondary market is complex and doesn’t have to be understood by the borrower. Regardless of who actually owns what part of the loan, they will be earning the interest rate agreed upon during the origination process.
- In order to keep the backend ownership and changes in that ownership opaque to the borrower, there is a mortgage servicer who actually takes in the borrower’s monthly payments on behalf of the actual owners. They take care of distributing these monthly payments accordingly.
- The servicer, the borrower-facing business, can change over time as well. One servicer may sell the account to another and the borrower would then make payments to a different business, but keeping to the origination agreement.
- Home mortgage agreements normally contain no prepayment penalty. This means the borrower can payoff the outstanding loan amount any time and will not incur any penalty for the lost income stream to the lender. This means that the loan can be closed out at any point in time and the lender needs to be prepared for it. On a payoff, the loan ceases to exist.
Let’s take a look at the above from the viewpoint of a borrower:
- The borrower applies for and obtains a mortgage loan with certain terms. These terms are generally the interest rate to be paid on the outstanding capital and how long the payments can take in time. Typical durations are 30-year and 15-year periods from the time the loan was originated.
- The borrower makes monthly payments to the loan servicer on record. The amount paid is in accordance with the agreement at the time of origination.
- Even with a significant capital still outstanding, the borrower can payoff the mortgage by refinancing, that is borrowing, using a new set of terms, enough money to pay off the earlier mortgage. Note that there is no assumption that the new lender must be different from the original lender.
The original question
Now, back to the question that started it all.
Why would a lender actively encourage a borrower to refinance in order to reduce the interest rate?
We will never know the true answer, but it is normally without any malice. Some of the possible reasons:
- Different departments may handle mortgage origination and mortgage servicing, and they may not talk to each other. The origination department may be unaware that they are acting to reduce the earnings on the current mortgage note held.
- Lenders expect borrowers, as a rule, to refinance to reduce their interest rate by watching the market. As a result, to earn the origination fees, it is good practice to promote without worrying about whether the borrower already has a mortgage loan with the organization. If they don’t promote, someone else’s promotion may prevail!
- The origination department is aware of the current relationship with the borrower, but may seek a new loan anyway to retain them as a borrower, with the possibility of increasing the capital or loan duration, or both.
Therefore, the borrower should not try to second guess why they received a promotion. Rather, they should use it as a stimulus to take a look at the market; evaluate and decide for themselves whether there is any reason to consider a refinance at that time.
Sounds good. How to evaluate?
This is a huge topic. It deserves its own discussion. We’ll cover it in a future post. As a glimpse of the issues involved, let me mention a few:
- Fixed vs. Adjustable mortgages
- 15 or 30 year mortgage? (Or others too, like 10 year, 20 year and the like)
- Monthly payments change
- Total interest payments
- Cash-out financing
- Why increasing your interest rate may even be justified
- Break-even analysis
- and more …
So, as long as you follow the steps to evaluate your needs and come to a decision using your own analysis, there is no need to second guess why a particular lender is asking you to refinance. Their promotions are just reminders for you to be constantly vigilant.