Investors’ reactions to VA prepayment rates also affect the wider mortgage market. Because FHA and VA mortgages are sold to investors as part of a single Ginnie Mae securities pool, they are very liquid, making it easy for an investor to buy and sell. When investors decide what price to pay for the security, their bid reflects the prepayment characteristics of the worst pool of mortgages—that is, the pool with the highest percentage of VA mortgages. As a result, the higher interest rate set by investors because of the VA mortgages is applied to FHA borrowers as well. As a group, FHA borrowers have lower incomes and lower credit scores than VA borrowers, meaning the higher rates can take a larger financial toll.

Originators can and do trade FHA mortgages separately, but the practice is expensive for both borrowers and lenders. Custom pools, like an FHA-only Ginnie Mae pool, have more limited liquidity than a typical good-delivery Ginnie Mae pool. When an investor buys a good-delivery Ginnie Mae pool, they buy a contract for the delivery of loans of a given coupon and maturity bucket. Although the exact mortgages are determined at a later date, the pool is guaranteed to meet the preset standards, producing a deep and liquid market. Custom pools are not classified as good delivery, compromising their liquidity.  

How do current policies encourage marginal refinances?

At first glance, the VA streamlined refinance policies make sense. Mortgages must be at least 7 months old, and the savings on monthly payments must allow for any associated fees to be recouped in 36 months or less. In addition, the interest rate savings must be at least 50 basis points for a fixed-to-fixed refinancing.

But these policies allow a borrower to roll any associated fees into the loan amount, which makes it hard for the borrower to evaluate the actual savings. In an environment where rates are only marginally lower, a borrower may feel encouraged to refinance to their detriment, letting the lender profit from the fees associated with the refinancing and taking on a higher loan balance.

Consider this example. In an environment with a market interest rate of 6.5 percent, a borrower agrees to a 7 percent mortgage and finances the VA fee of 2.15 percent into their loan amount. Their monthly payment comes out to $1,996. After a year, the borrower has paid down the loan balance to $289,953 and decides to refinance at a 6.5 percent mortgage rate, rolling the 0.75 percent origination fee and 0.5 percent VA fee into the loan amount. Their monthly payment drops to $1,904, but their loan amount increases to $300,655.

This refinance passes the VA net tangible benefit test because the borrower saves $92 a month and the origination fee ($2,227) is recouped in 24 months. Additionally, the rate differential is 50 basis points. But the borrower’s repayment term and loan balance have increased, representing a loss in home equity.

Fundamentally, the annual percentage rate (APR) calculation regulators and the mortgage industry use treats costs and fees rolled into the loan amount differently than costs and fees rolled into the rate. A $300,000 mortgage with closing costs of 2 percent has an APR of 6.69 percent, while the same mortgage with the closing costs rolled into the rate has an APR of 7 percent. This 31 basis-point difference stems from the ability to amortize the costs over 30 years when the closing costs are rolled into the loan amount instead of the rate. Because most borrowers don’t live in their home for 30 years, the APR calculated using the 30-year amortization is misleading.

Making VA refinancings more affordable

To ensure that VA borrowers have all the information necessary to know whether they should refinance, the solution is clear: The VA can require that all closing costs on a streamlined refinance must be paid in cash or rolled in the rate; the loan amount cannot increase at all. With these parameters, the borrower and lender can compare the rate on the old mortgage with the APR on the new mortgage. If the savings are more than 50 basis points, the refinancing can proceed.

That is, we propose that borrowers without the cash on hand to cover the savings can roll the closing costs into the rate, giving them a clearer picture of the costs. If the borrower needs to add the closing costs to their loan amount, they can opt to do a cash-out refinance, which is not streamlined and requires additional documentation. This approach has four advantages:

• By eliminating the borrower’s ability to roll the closing costs into the loan amount, we can give the borrower a better picture of the true costs of refinancing.
• The borrower does not give up the home equity they have already banked.
• By leaving the loan amount constant, the risk to the insurer or guarantor on the refinancing drops.
• Mortgage rates would decrease for FHA and VA borrowers.

The current combination of a streamlined refinance program and the ability to roll all closing costs into the rate has led to refinances against the borrower’s interest and has resulted in higher mortgage rates for FHA and VA borrowers. Our easy-to-implement proposal—requiring that the loan amount remain unchanged in a streamlined VA refinance—would go a long way toward correcting these issues.