Academic

Tales From a Refinancing

By Gordon Smith, Christine, Hurt, Vic Fleischer, Fred Tung, Lisa Fairfax, David Zaring

The financial meltdown has many narratives, and many of them revolve around investors in mortgage-backed securities not knowing the risks of their investments and the borrowers in the underlying mortgages not knowing the risks of their investments.  My own brief experience with the mortgage industry this quarter has driven this latter point home.

In January, inspired by others we knew refinancing their mortgages, we contacted our mortgage holder and inquired about refinancing.  We bought our house in 2006 at 5.625%, so we knew that the pros and cons would be close, depending on the rate, fees, etc.  But, since our money wasn't making a positive return on any of our investments, we figured that paying a higher rate of return wasn't that palatable, either.  Our mortgage holder promptly emailed us five spreadsheets that were completely indecipherable to us.  When we asked questions, the answers made no sense to us.  Luckily, my colleague who officed next to me was the director of our Transactions and Economic Development Clinic, and she had mentioned that she recently had helped a neighbor determine whether refinancing was economically smart.  My corporate finance tail between my legs, I asked her if she could make heads or tails out of the spreadsheet.  She had to spend thirty minutes reviewing it to understand where all the numbers were coming from and what the bottom line was.  The bottom line, she said, was that the refinancing was going to cost $5000, or somewhat less than 2.5% of the loan.  Plus, the $5000 was tacked on to the loan, adding cost in interest and fees.  She encouraged us to "shop around" when our original mortgage holder would not negotiate on the fees.

So, we finally went with a local bank, who presented us our costs in more of a term sheet fashion, outlining a handful of fees that amounted to around $1000 for the same principal amount and interest rate.  The bank did warn us that although we were locked in at that rate (4.5%), the backlog of refinancing applications would take awhile to work through.  They weren't joking!  We signed the closing papers Wednesday on the refinancing we were approved for in January.  Although there were a few hiccups (because of the backlog, the payoff amount the bank received did not include the April payment, etc.), the documents were much easier to understand.  The local bank also explained that they kept their mortgages.

So, what was interesting to me about all of this?

I am quite willing to believe that many who sign mortgages and particularly refinance documents have no idea what the costs are or what their ending principal balance is.  If a corporate finance attorney could not figure out the loan documents and had to ask someone who is an expert in consumer finance documents, then we should not expect those with other types of work/life experiences to be able to do a better job.  If it wouldn't scandalize my co-borrower to show your our private finance life, I would post the spreadsheets so that you could get a flavor for the dizziness.

When people are faced with financial documents they don't understand, a first instinct is to say "Just tell me where to sign."  I'm ashamed to say that I gave up very easily when I couldn't make heads or tails out of the document and the answers to my questions were even more confusing.  I could feel myself think, "It's probably fine.  I should just go with it."  If I hadn't had a trusted friend to turn to, we might either have overpaid for the refi or just gave up on it altogether. 

When borrowers don't understand the loan documents, they don't have a lot of options.  No one likes to ask for help, especially with financial questions, but you also need someone to ask.  I wasn't really sure I wanted my friend to know how much my house was worth (sort of silly in Champaign where all the houses in our subdivision cost the same amount!) or how much equity we had in it.  I also didn't want her to know that I couldn't figure out what all the line items were or what the bottom line was.  But I feel very lucky to have had her available to me as long as I swallowed my pride.  For someone applying for a refinancing without friends in the finance world, who would she turn to?  Unless the borrower has a neighbor who is the director of a clinic that helps people with consumer finance, then she may not be able to find anyone better able than she is to make a rational refinancing decision.

With all the laws to make consumer lending more transparent, why is it so opaque?  In my practice, I often created or reviewed term sheets for commercial loans and corporate bonds.  Those term sheets were in English and made sense.  Why would documents in a consumer financing be so hard to understand?  At our closing, the "Uniform" documents the bank had to use were the most confusing.  The documents that were generated in-house, including a two-page letter telling us what the principal amount was, the interest rate, the term, and the fees, was the simplest.

Full post as published by Conglomerate on April 09, 2009 (boomark / email).