Mortgage Refinancing is Easy
By: Prof. Dr. Budi Frensidy – Professor of FEB UI
KONTAN – (27/6/2022) Two years ago, when inflation and market interest rates were at their lowest, let us say you took out a home ownership loan (KPR) valued at Rp500 million from a bank. The mortgage has an effective interest rate of 6% p.a. for 120 months, with monthly installments of Rp5,551,025.
The credit contract signed together states that the interest rate of 6% p.a. will be evaluated after two years. In addition, the debtor will be subject to a 2% penalty for early repayment.
After two years of installments, it turned out that inflation had accelerated. As a result, the interest rate has increased. Your mortgage interest rate has also increased to 10.5%.
If your monthly installment was previously Rp5.55 million, it is now Rp6,521,963, an increase of 17.5%. How should you deal with the bank’s decision?
Some might suggest that you stop paying your monthly installments. This is certainly not a wise thing to do. If you do this, you will end up losing instead of gaining.
Remember, the bank will always charge interest on the outstanding balance. The value of your outstanding mortgage balance will increase if this stance is taken.
A more reasonable opinion would suggest that the mortgage should be paid off immediately if the interest rate is increased without your consent and transparent basis. As for the amount, it is certainly not as much as Rp400 million (calculated from 96/120 x Rp500 million) as many people think, but more than that.
We all know that every credit installment consists of two components, namely interest payments and principal repayments. For the initial period, most of the installment is to pay interest.
The correct mortgage balance is now Rp422,406,466. This number can be easily found by understanding financial math, one of the books I wrote. You can use excel, a financial calculator, or a scientific calculator to get the above number.
Because of the 2% penalty, a repayment fund of Rp430.85 million is required. If you have the money now, pay off your mortgage, whose interest rate was increased without reference.
What if you do not have that money? If you are smart, you will try to refinance, which means paying off the old mortgage with a new mortgage at a lower interest rate. Due to the competition between banks in lending, new mortgage interest rates are generally lower than the adjusted interest rates.
As long as the new mortgage installment is smaller than the old one, without you depositing additional funds at all, for the same period of 96 months, refinancing should be done. Unlike individuals, corporations have often practiced debt or bond refinancing like this to save on interest costs.
Therefore, look for information on other banks’ mortgage rates, procedures for transferring your mortgage, and fees charged. Suppose another bank is willing to take over your mortgage and offers an effective interest rate of 7.5% p.a. for 96 months. In addition to the interest charges, assume there are provision, administration, and credit pass fees that total 1% of the mortgage balance.
Is the new mortgage to be applied for Rp430.85 million? Because of these 1% bank charges, you will only receive Rp426.55 million if you only apply for Rp430.85 million. That is not enough to pay off the old mortgage.
You will have to spend Rp4.3 million from your pocket for the new bank provision fee. Therefore, the amount of the new mortgage you need to apply for is Rp435,206,662. With this amount of money, your old mortgage will be paid off.
More importantly, you ensure you don’t spend a single rupiah for this refinancing process. This method is not to be stingy but just to facilitate cost-benefit analysis. With this approach, we will know the amount of savings from refinancing.
After refinancing, you still have an obligation to pay 96 monthly installments, but to the new bank that provides the mortgage of Rp435.2 million above. With the new mortgage interest rate of only 7.5% p.a. effective, the monthly installments will be only Rp6,042,353.
The benefit you get is the difference between the old mortgage installment and the new one, which is Rp479,610 monthly. Alternatively, totaled value is around IDR 46.04 million for 96 months.
If examined, the difference in mortgage interest rates is about 3% per year, and for the remaining 8-year period, the savings should be around 24%. However, why is the savings not that big, only about half?
The reason is the prepayment penalty (2%) and the various bank charges (1%) that have to be paid now. While the benefits above are for 96 months. These two factors must be considered carefully in refinancing because they will erode the benefits you get as a debtor.
That is, if the mortgage period is only one or two years, refinancing should not be done because it is very likely that the costs outweigh the benefits. The more significant the difference in mortgage interest rates and the longer the remaining period, the greater the benefits of refinancing.
Conversely, the higher the early repayment penalty and the higher the fees charged by the new bank, the smaller the benefit. Are you still thinking of refinancing your mortgage? Make sure you do a cost-benefit analysis like the one above.
Source: Kontan Newspaper. Edition: Monday, June 27, 2022. Portfolio Rubric – Wake Up Call. Page 4.