Refi before sale can backfire

Homeowners who anticipate that they will be selling their house within a few years want to net as much from the sale as possible. The usage of the verb "net" indicates that what matters is not how much they receive for the house but how much they have left after repaying the mortgage. Real estate agents counsel borrowers on ways to get the best sale price, such as repairing obvious defects, keeping the house sparkling clean for potential buyers to view, and so on. But some owners view an impending sale as a way to save money on the mortgage if they can refinance into a lower payment. The borrowers who do this often ignore the impact of the refinance on the size of the loan balance that they will have to pay when they sell. Here is an example: The current balance on a 4.125 percent mortgage is $300,000, with a payment of $1,685 and 23 years remaining. The borrower expecting to sell in two years refinances into a new interest-only adjustable-rate mortgage (ARM) at the same rate, reducing the payment to $1,031.

The refinance cost is $6,000, but the borrower reduces his payment by $654, which over two years sums to $15,696. Hence, by his logic, he is ahead by $15,986 minus $6,000, or $9,986.

What he has overlooked is that if he had stayed with his existing mortgage, he would have paid down the balance by $16,307, which would have resulted in net proceeds at sale $16,307 larger. His supposed gain of $9,986 is actually a loss of $6,321.

Of course, if the new loan has a significantly lower interest rate than the existing loan, the refinance could result in larger net proceeds at sale. But if the refinance is profitable over a short period, it would be even more profitable over a longer period, which means that the borrower should do it despite an impending sale rather than because of it.

Can you time a lock to your advantage? Home mortgage prices are based on the secondary market prices of mortgage-backed securities (MBSs), but changes in MBS prices seldom impact mortgage prices immediately. Typically, mortgage lenders set the prices they deliver to their loan officers and mortgage brokers in the morning, after markets open, and keep them unchanged through the day unless MBS changes during the day are large enough to justify the cost of another change.

The MBS market closes at 3 p.m. Eastern Standard Time (EST). Mortgage borrowers who have been cleared to lock by their lender can do it between 3 p.m. and 5 p.m. EST, and sometimes even later. In principle, therefore, a borrower who knows what happened to MBS prices that day could judge whether mortgage prices the next morning would be higher or lower, and therefore whether they should lock then or wait another day.

Some advisors encourage borrowers to lock as soon as possible, on the grounds that 1) borrowers can't predict future interest rates, and 2) locking ASAP may prevent larcenous behavior by the lender. Jack Guttentag is professor of finance emeritus at the Wharton School of the University of Pennsylvania.

By Jack Guttentag