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I heard someone say that he refinanced his house, and reinvested the money into the mortgage to lower his monthly payments.

What I don't understand is:

  1. Since there was no sale, where does the money actually come from?
  2. How does a bank profit from this, i.e why would they willingly help someone lower their mortgage payments?
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3 Answers

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A re-financing, or re-fi, is when a debtor takes out a new loan for the express purpose of paying off an old one. This can be done for several reasons; usually the primary reason is that the terms of the new loan will result in a lower monthly payment. Debt consolidation (taking out one big loan at a relatively low interest rate to pay off the smaller, higher-interest loans that rack up, like credit card debt, medical bills, etc) is a form of refinancing, but you most commonly hear the term when referring to refinancing a home mortgage, as in your example.

To answer your questions, most of the money comes from a new bank. That bank understands up front that this is a re-fi and not "new debt"; the homeowner isn't asking for any additional money, but instead the money they get will pay off outstanding debt. Therefore, the net amount of outstanding debt remains roughly equal. Even then, a re-fi can be difficult for a homeowner to get (at least on terms he'd be willing to take). First off, if the homeowner owes more than the home's worth, a re-fi may not cover the full principal of the existing loan. The bank may reject the homeowner outright as not creditworthy (a new house is a HUGE ding on your credit score, trust me), or the market and the homeowner's credit may prevent the bank offering loan terms that are worth it to the homeowner. The homeowner must often pony up cash up front for the closing costs of this new mortgage, which is money the homeowner hopes to recoup in reduced interest; however, the homeowner may not recover all the closing costs for many years, or ever.

To answer the question of why a bank would do this, there are several reasons:

  • The bank offering the re-fi is usually not the bank getting payments for the current mortgage. This new bank wants to take your business away from your current bank, and receive the substantial amount of interest involved over the remaining life of the loan. If you've ever seen a mortgage summary statement, the interest paid over the life of a 30-year loan can easily equal the principal, and often it's more like twice or three times the original amount borrowed. That's attractive to rival banks.

  • It's in your current bank's best interest to try to keep your business if they know you are shopping for a re-fi, even if that means offering you better terms on your existing loan. Often, the bank is itself "on the hook" to its own investors for the money they lent you, and if you pay off early without any penalty, they no longer have your interest payments to cover their own, and they usually can't pay off early (bonds, which are shares of corporate debt, don't really work that way). The better option is to keep those scheduled payments coming to them, even if they lose a little off the top.

    Often if a homeowner is working with their current bank for a lower payment, no new loan is created, but the terms of the current loan are renegotiated; this is called a "loan modification". Historically, the idea of giving a homeowner a break on their contractual obligations would be comical to the bank. In recent times, though, the threat of foreclosure (the bank's primary weapon) doesn't have the same teeth it used to; someone facing 30 years of budget-busting payments, on a house that will never again be worth what he paid for it, would look at foreclosure and even bankruptcy as the better option, as it's theoretically all over and done with in only 7 years. With the Government having a vested interest in keeping people in their homes, making whatever payments they can, to keep some measure of confidence in the entire financial system, loan modifications have become much more common.

  • Sometimes, a re-fi actually results in a higher APR, but it's still a better deal for the homeowner because the loan doesn't have other associated costs lumped in, such as mortgage insurance (money the guarantor wants in return for underwriting the loan, which is in turn required by the FDIC to protect the bank in case you default). The homeowner pays less, the bank gets more, everyone's happy (including the guarantor; they don't really want to be underwriting a loan that requires PMI in the first place as it's a significant risk).

  • The U.S. Government is spending a lot of money and putting a lot of pressure on FDIC-insured institutions (including virtually all mortgage lenders) to cut the average Joe a break. Banks get tax breaks when they do loan modifications. The Fed's buying at-risk bond packages backed by distressed mortgages, and where the homeowner hasn't walked away completely they're negotiating mortgage mods directly. All of this can result in the homeowner facing a lienholder that is willing to work with them, if they've held up their end of the contract to date.

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Thanks, that's a very detailed answer. Just to clarify, banks profit from re-fis mainly because they no longer own the original loan. If they had kept the mortgage, they would have no incentive to modify your loan (at least, not in a way advantageous to you). Is this correct? –  alekop Jan 24 '13 at 0:19
    
Refinancing generally isn't initiated by the bank you have your loan with. If you refi with the same bank they are essentially giving you a discount. Usually another bank does it to get your business (the loan/interest) away from the first bank. The bank with the current loan may re-fi as incentive to keep you from doing that. –  JohnFx Jan 24 '13 at 3:24
    
@alekop - If you have a mortgage with one bank, and another bank offers you better terms and you refinance, the new bank profits because they are now receiving the interest on the money. The old bank was paid off the full amount of the principal and any accrued interest, but all those expected future interest payments will no longer happen. That can result in a net loss for the old bank if the money they lent you was in turn borrowed by selling bonds (extremely common), because they usually can't pay early the way you did. –  KeithS Jan 24 '13 at 18:29
    
Note that some mortgages have prepayment penalties, though they're not common in the US these days. Prepayable debt is actually fairly rare outside the mortgage market; it's usually more expensive than non-prepayable debt and raises the overall risk to the lender (which is reflected in slightly higher mortgage interest rates). –  fennec Jan 28 '13 at 16:48
    
Actually, in the U.S. you'd be hard-pressed to find debt other than a mortgage that has a prepayment penalty. You sometimes see it in car notes; that's pretty much it, and it's rare even in those two loan types. It's one of the pieces of information that have to be displayed up front in no uncertain terms as part of truth-in-lending legislation, and if someone who has any choice in lenders at all sees that penalty, either it's gone or he is. Too many other lenders want your business for you to mess with someone who wants a prepayment penalty. –  KeithS Jan 28 '13 at 23:20
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You owe $20,000 to a loanshark, 1% per week interest. I'm happy to get 1% per month, and trust you to pay it back, so I lend you the $20,000.

The first lender got his money, and now you are paying less interest as you pay the loan back. This is how a refi works, only the first bank won't try to break the legs of the second bank for moving into their business.

This line "reinvested the money into the mortgage to lower his monthly payments" implies he also paid it down a bit, maybr the new mortgage is less principal than the one before.

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Yes, he used the money to pay down the principal. I just didn't understand why the bank would be motivated to help him do that, but since the re-fi is done by a different bank, that makes sense. –  alekop Jan 24 '13 at 0:49
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Keep in mind, my example was a bit oversimplified. Evn if the bank was the exact same bank, when rates drop, they would still offer you a new loan because if they don't, the next guy will. –  JoeTaxpayer Jan 24 '13 at 2:13
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Since there was no sale, where does the money actually come from?

From the refinancing bank. It's a new loan.

How does a bank profit from this, i.e. why would they willingly help someone lower their mortgage payments?

Because they sell a new loan. Big banks usually sell the mortgage loans to the institutional investors and only service them. So by creating a new loan - they create another product they can sell. The one they previously sold already brought them profits, and they don't care about it. The investors won't get the interest they could have gotten had the loan been held the whole term, but they spread the investments so that each refi doesn't affect them significantly.

Credit unions usually don't sell their mortgages, but they actually do have the interest to help you reduce your payments - you're their shareholder. In any case, the bank that doesn't sell the mortgages can continue making profits, because with the money released (the paid-off loan) they can service another borrower.

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Often a lender who sells the loans to a larger bank will still continue to service the loan for that other bank, and collect fees for doing so. Nice work, if you can get it; the other bank shoulders most of the risk, and you handle the day-to-day of creating, disbursing, and collecting for your bread and butter. –  KeithS Jan 23 '13 at 23:49
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