According to the ABS, the number of people refinancing their mortgage increased by over 63% in the year to May 2020. Quite often people think the only reason to refinance is to obtain a lower interest rate. However, this thinking is incorrect. Typically, you don’t need to refinance to obtain a lower interest rate (more about this below). As an experienced investor myself, I can tell you that there are far more important reasons to refinance your loans.
What is a refinance?
This might sound like a basic question. However, there are two types of refinances; internal and external. A refinance essentially involves entering into a new loan agreement. You can do that with your existing lender/bank, and this is called an internal refinance. Alternatively, you can switch to a new lender and this is called an external refinance. This distinction is important for my discussion below.
The first two reasons are the most important
Over the past 20 years, the primary motives for refinancing my personal mortgages were because of the first two reasons below. I’ll share why later in this blog.
Reason # 1: restructure your loans
Your loan structure can have a big impact on your cash flow and ability to invest. Restructuring your loan repayments, how loans are secured, loan terms and so on can provide substantial financial benefits. Here are a few examples:
Resetting your interest only term
As I explained in a blog last year, interest only terms typically run for 5 years only. Once that initial 5-year term expires, most (but not all) lenders allow borrowers to rollover onto an additional 5-year term. However, once you have used two 5-year terms, the only way to get another is to complete an external refinance, and switch to a new lender.
Resetting your loan term to 30 years
Almost all loan contracts are based on a 30-year loan term. If you elect to repay interest only, then your 30-year term will be split into two parts; one 5-year interest only term and the remaining 25-years on principal and interest (P&I) repayments. Therefore, if you use two 5-year interest terms (a second interest only term is typically only permitted for investment loans) and then switch to P&I repayments, your repayments will be based on the remaining term of 20-years. This will increase your minimum repayments. For example, repayments on a $800,000 loan over 20 years are approximately $4,440 per month. However, refinancing the loan to back to 30-years reduces the repayments to $3,380 per month thereby improving a borrower’s cash flow. You can achieve this by completing either an internal or external refinance.
Release security, especially if you are planning to sell a property
It is important that loans are structured correctly to minimise your risk (minimise security), maximise control and ensure tax deductions are never compromised. To this end we often assist clients in restructuring their loans which could include unwinding cross-securitisation, consolidating loan accounts, splitting accounts, releasing property as security and so on.
If a client plans to sell a property, we will consider doing two things in advance. Firstly, where possible, we will release that property as security. This ensures that bank has no control over the sale funds. Secondly, we will consider whether to retain the existing loan to preserve the client’s borrowing capacity.
Reason # 2: maximise borrowable equity
Maximising your borrowable equity is important as accessing additional capital will help you build your investment portfolio and/or achieve your lifestyle goals.
Bank valuations can differ materially
It is not uncommon for a valuation of the same property by two different banks to differ by several hundreds of thousands of dollars. This can be the difference between being able to acquire another property, or not. Therefore, it is important to have a realistic assessment of the value of your property and then find a bank/valuer that shares your viewpoint.
Higher borrowing capacity
Each bank will have a different borrowing capacity for different client scenarios. These policies can change over time. As such, it’s possible that the lender with the highest borrowing capacity today, might have one of the lowest borrowing capacities 5 years from now. If your lender changes its policies or your circumstances change, it might necessitate a change in lenders.
Put some distance between a previous credit assessment
Sometimes it’s important to switch to a new lender to benefit from a fresh pair of eyes. For example, if your existing bank has determined they don’t want to lend you anymore money, then you need a brave credit manager to overturn that decision, even if a few years have elapsed (since that decision was made). That could be the case even if your financial position has improved.
However, a new lender isn’t influenced by any previous credit assessment. Instead, it will focus solely on the merits of your application.
Reason # 3: reduce overall cost
The third reason is to obtain a lower interest rates and/or fees. However, as I explain below, you may not need to refinance to a new lender to achieve this.
The typical attraction of refinancing to a new lender is because they either offer you a higher variable rate discount or they offer the lowest fixed interest rates.
Many lenders are offering cash incentives of between $2,000 and $4,000. This more than offsets the cost associated with refinancing. Refinancing typically incurs three fees:
- Your incumbent lender will charge a discharge fee to deal with the administrative aspects. This is normally around $300 per loan.
- Your new lender will charge a settlement fee – again to deal with the administrative aspects of setting up the new mortgage. This fee is approximately $200 per loan.
- Mortgage deregistration and registration fees. These are government fees and depend on the state the mortgage is registered in. These fees usually range between $200 and $300 per property (security).
How to get a lower rate without refinancing
Most lenders will offer borrowers higher discounts to retain your business. But, of course, they won’t do that proactively. You must ask! Also, the lender must know that you are prepared to walk if they don’t reduce your interest rate. This is why it’s important to cite a competitive offer.
If you need any guidance with doing this, please don’t hesitate to drop Jodi an email.
You should do this before contemplating switching lenders.
Why are the first two reasons the most important
The first two reasons are important because they help you safely extend your borrowing capacity. Borrowing is a scarce resource. That’s because its supply is finite – no one has an infinite borrowing capacity. We all have a limit on the amount we can and should borrow. This limit could be restricted by your financial position or risk appetite. Or perhaps its restricted by the banks.
The important thing is that you take steps to safely maximise it. Doing so will ensure you have access to as much capital as possible to continue to build your investment portfolio and achieve your lifestyle goals.
How often should you refinance?
Speaking from personal experience, as an investor that is actively building wealth, I have typically refinanced every 2 to 4 years. I never plan to leave my existing lender/s. But if they start saying no, I don’t listen to them. Instead, I find a lender that will accommodate my realistic plans. That has allowed me to continue to achieve my financial and lifestyle goals.
If you are not an active investor, then it’s very possible that you won’t need to refinance as often.
Beware. Refinances take time
There’s almost no such thing as a quick refinance, especially since lenders back-office processing has been adversely impacted by the Covid lockdowns here and overseas. Depending on the lender, refinances can take 2 to 3 months to complete – from start to finish.
When it comes to refinancing, patience is definitely a virtue.