Refinancing Vs Contract Modification

February 5, 2001, Revised June 29, 2007

"I recently read an article that said that savvy borrowers could avoid the costs of refinancing by getting their lender to agree to a modification of the rate on the existing loan. If the old loan stays on the books, the settlement costs of a new loan are avoided. He said he got his loan modified for $35. Why is this not a widespread practice?"

The short answer is that most loans are serviced by firms that don't own the loan, and owners do not give servicing agents the discretion to modify the rate.

When market interest rates drop, a lender would rather drop the rate on a fixed-rate mortgage in good standing than lose it to another lender through a refinancing. On the other hand, if the borrower isn’t going anywhere, the lender doesn’t want to drop the rate. The lender’s objective is to drop the rate only if necessary to prevent loss of the loan.

If the lender is servicing its own loans, it may allow rate modifications for borrowers who request it. The writer who had his loan rate modified for $35 was one of them. But this doesn’t happen very often. The writer belonged to a dwindling group of borrowers whose loans are owned by lenders who do their own servicing.

Most loans today are serviced by lenders who don't own them. They sold the loans soon after closing and are now servicing agents of the owners. Except under special arrangements of the type described below, the owners do not grant their servicing agents the right to modify the interest rate.

This reflects a conflict between the interest of the owners and the interest of the servicing agents. Owners fear that if agents had the discretion, they would agree to rate reductions too readily because they lose nothing from a rate reduction.

Servicing agents make their money from a servicing fee, usually 1/4% of the loan balance. The fee is deducted from the borrower's payment before the agent remits the remainder to the owner. A rate reduction that retains the customer protects the agent’s servicing fee but hurts the owner.

There are ways to reduce this conflict in order to make rate modifications possible. One approach is to charge the borrower a fee for the right to have the rate reduced in the future, with the fee split between the servicing agent and the owner. Countrywide Home Loans and Wells Fargo Home Mortgage have programs of this sort developed in collaboration with the Federal agencies Fannie Mae and Freddie Mac, who buy the mortgages from them. These programs have not had much market impact to date.

While lenders will seldom allow servicing agents to reduce rates, they don't want their loans being refinanced with other lenders either. Hence, they allow and even encourage their agents to adopt "loan retention programs". Under these programs, the agents attempt to identify borrowers who are likely to refinance, and try to head them off at the pass with their own refinancing proposal.

Because loan retention programs create a new mortgage, they generate settlement costs. Some lenders, and the major Federal agencies Fannie Mae and Freddie Mac, have offered "streamlined refinance" options. These programs reduce the required documentation and costs when lenders refinance loans that they have been servicing, for which they have the borrower’s payment history right at hand.

A few lenders have combined streamlined refinance with "no-cost" mortgages to offer programs where borrowers can refinance at little or no cost whenever interest rates decline. A widely publicized program of City Line Mortgage allows borrowers to refinance by paying only for title insurance. All other settlement costs are borne by City Line.

City Line prompts borrowers when the market has fallen .5% or more below the rate on their mortgages. The borrower must request the refinance and must have a good payment record, but City Line does the work using "streamlined refinance" rules set forth by their investors.

The appeal of this program to borrowers is that refinancing is quick and easy, the refinancing cost is very low, and the lender prompts them when the opportunity is there. The downside is that borrowers pay an above-market rate when they take out their loan.

On January 11, 2001 I found that City Line’s quoted price for new customers on a 30-year fixed-rate mortgage was about .625% above the rate available from three mortgage shopping sites. That’s a stiff price to pay for a low-cost refinance option.