Periodic Mortgage Refinancings: Who Gets Conned?

 January 25, 2001, Revised November 26, 2008

"I have a friend who refinances his home every three months. He has refinanced six times in the last two years. His mortgage broker buddy gives him a kickback of about $5,000 every time he refinances. He wants me to do the same deal and I'm tempted, but I'm concerned that it may be illegal or have other bad consequences."

Your friend is a fool. Do not copy him. He is borrowing at an exorbitant price and depleting the equity in his home. The mortgage broker pockets a fee with every refinance, and is scamming the lenders who write the new loans.

The market distinguishes two types of refinance transactions. One is designed to reduce the borrower's interest cost when interest rates decline. These refinances fell drastically last year as interest rates rose, and currently there are very few.

In cost-reduction refinances, lenders allow you to include the settlement costs in the new loan balance. For example, if the loan balance is $100,000 and settlement costs are $3,000, lenders will allow the new balance to be $103,000. But any loan amount higher than $103,000 would put cash in your pocket and be considered a "cash-out" refinance.

Cash-out refinances have higher default rates than cost-reduction refinances. This may be because borrowers reduce their equity, or because their need for funds reflects financial distress. Whatever the reason, lenders typically charge higher interest rates or points to cover the extra risk.

Your friend's mortgage broker is conning the lenders he represents by passing off a cash-out refinance as a cost-reduction refinance. He does this by padding the settlement costs and paying your friend the difference. For example he reports $10,000 in settlement costs when they are only $5,000. The extra $5,000 goes into your friend's pocket.

Who is getting conned? Everyone but the mortgage broker.

The lender is being conned into writing a loan that won’t last long enough to cover the costs. The broker deals with a stable of lenders, so he can move the loan from one lender to another without raising suspicions. Some borrowers do legitimately pay off loans within six months.

Your friend is bound to stop refinancing at some point, perhaps when his equity has been entirely depleted. The last lender in the sequence will own a cash-out refinance masquerading as a cost-reduction refinance.

But your borrower friend is also getting conned into paying an exorbitant price for a small loan. Each time he refinances, he increases the debt on his house by the amount of the money he puts in his pocket plus the real settlement costs and the broker's fee. For example, assuming he takes $5,000 out of the deal and adds $10,000 to the balance on an 8% 30-year loan, and that he then holds the loan to term, the effective cost of that $5,000 is 17.5%. If he refinances again after 12 months, it is 83.7%.

Your foolish friend would save money if he simply obtained a home equity loan.

August 27, 2003 postscript

There is a more sophisticated version of this scam that is attractive because the borrower's balance does not rise. The broker refinances the borrower into the highest rate offered by the lender, which carries the largest rebate (negative points). The rebate covers settlement costs, and the balance is split between the broker and the borrower. While the borrower loses on the higher rate, the loan is refinanced about every three months, so the borrower's share of the rebate is larger than the loss from the higher rate. The broker moves the loan from one lender to another so that none of them catch on to what he is doing.

So long as this game continues, both borrower and broker can profit. The game will terminate, however, when lenders get wise and stop doing business with the broker. At this writing, some lenders had begun to require brokers to repay rebates when a loan is paid off within 6 months. When the game ends, the borrower is left with his high-rate mortgage.

November 26, 2008 Postscript

One borrower who wrote me recently about getting involved in this kind of scheme argued that the lender knew about it and didn't care. This made me realize that I had been loose in my use of the term "lender". The party who loses on these deals is whoever ends up with the loan and finds that they have paid a premium price for a high-rate loan that they expected to have for 2-3 years, but which is paid off in 3 months. The lender who doesn't care is one who sells the loan.