Blended Rates

Blended rates are just what the name implies – two or more loan interest rates combined together to yield a more advantageous final rate for the borrower. They usually make the most sense when the gap between the old and current interest rates is great, and new mortgage money rates are high. Here's a basic example of how blended rates work:

The Moneysmiths have a home worth approximately $150,000 and their current mortgage balance is $90,000 at 5 percent interest. They want to pull an additional $30,000 out of the property to add a family room, but they're not very happy about refinancing with new first mortgage money because rates are running at 7 percent. The other option of second mortgage money at 8 percent is also not overly appealing, so they decide to make a proposal to their current mortgage holder. Knowing the lender would like to move the old 5-percent loan off its books, the Moneysmiths ask that the lender make them a new first mortgage based on a blended rate of the 5-percent old money and the 7-percent new money. The new loan will be $120,000 for 30 years, with an interest rate of 5.5 percent. This moves the 5-percent loan off the lender's books, while giving the Moneysmiths a much more attractive overall rate of interest. (Technically, this is not a blended rate but the ,i>weighted average interest rate; the 5-percent old rate is weighted by $90,000, and the 7-percent new rate is weighted by $30,000. It is, however, a good approximation. The actual blended rate is calculated as the sum of all interest payments on the two mortgages over a specified time period, divided by the sum of all the balances of the two mortgages over the same period. If the terms of the two mortgages are the same, then the blended rate will be the same as the weighted average rate.)

Of course, the lender must realize a profit from this type of transaction also (or it would never be agreed to), so it may require some new origination and processing fees. And, as with most types of lending, if the borrower has other financing options, the pressure on the lender to make these concessions will be greater. For example, if the existing loan can be assumed, that's a point in the borrower's negotiating favor. If the interest rate on the underlying loan is at a rate much lower than current market interest, that's also a plus for the borrower. And if the borrower has cash on hand, letters of credit from other banks, or second mortgage alternatives with competing lenders, it all contributes to the borrower's stronger position.

It should also be noted that if a buyer takes out a second mortgage simultaneous with a first, the overall effect would be similar to that of blended rates. This could be seen if a lender were qualifying the buyer on ratios from the standpoint of the two interest rates and the loans' repayments. The lender would use the debt service on both loans in determining whether the buyer could qualify to handle both obligations.