Mortgage refinancing in 2001 and early 2002

Federal Reserve Bulletin, Dec, 2002 by Glenn Canner, Karen Dynan, Wayne Passmore

In recent years, millions of homeowners in the United States have taken advantage of relatively low interest rates and rising home values to refinance the mortgages on their primary residences. In many cases, refinancing has resulted in a lower interest rate and a reduction in monthly mortgage payments, which have allowed homeowners to spend or save that portion of their incomes no longer dedicated to servicing their mortgage debt. When they have refinanced, many homeowners have liquefied some of the equity they accumulated in their homes by borrowing more than they needed to pay off their former mortgage and cover the transaction costs of the refinancing. They used the funds raised in so-called cash-out refinancings to make home improvements, to repay other debts, or to purchase goods and services or other assets.

Choosing whether, and when, to refinance a home mortgage is a decision that involves a careful balancing of costs and benefits. Some of the factors to be considered are known with certainty and are readily quantifiable; others, such as the future course of interest rates, cannot be known with certainty. A homeowner with a mortgage is more likely to consider refinancing when the current interest rate on mortgages falls below the rate on the homeowner's existing loan. At such times, the homeowner must weigh the prospective after-tax savings from lower monthly payments on a new, lower-rate loan against the after-tax costs of the refinancing transaction itself, including any mortgage fees (points) and application and appraisal fees. Because the savings from lower interest payments accumulate slowly over time as the loan is repaid, the amounts that would be saved in a refinancing must be discounted to their present value and compared with the costs of the transaction, often referred to as the closing costs. (1) If the amount saved after tax over the long run exceeds the after-tax costs of the transaction, the homeowner stands to gain from the transaction. In addition, homeowners sometimes refinance to raise cash rather than to obtain a lower interest rate or to reduce uncertainty about future payments.

This article presents estimates, based on recent survey findings, of the incidence of refinancing, the changes in terms and conditions of mortgages after refinancing, the amount of funds homeowners raised in the process, and the ways in which homeowners used the funds. It also provides comparisons with previous surveys of refinancing activity and a statistical analysis of the relative importance of different determinants of refinancing and the amount of home equity liquefied during refinancing. Finally, it gives rough estimates of the effects of recent refinancing on the U.S. economy, including the effects on aggregate consumption spending.

SURVEY FINDINGS ON REFINANCING ACTIVITY

For many years, refinancing activity has been the focus of Board-sponsored surveys of households and of articles in the Federal Reserve Bulletin. (2) To learn more about recent refinancing activity, Fannie Mae and the Federal Reserve sponsored questions concerning mortgage refinancing in the monthly Surveys of Consumers from January through June 2002; these surveys were conducted by the Survey Research Center of the University of Michigan (for details see appendix A). The questions elicited information both on the characteristics of homeowners' current and past mortgages and on the use of funds raised in cash-out refinancings.

The Prevalence of Refinancing

As of the middle of 2002, about 63 percent of U.S. homeowners had an outstanding mortgage on their primary residence, owing on average about $100,000 (table 1). Home mortgage debt is commonly incurred for two reasons. Most homeowners need to borrow funds to finance the purchase of a home. Also, homeowners sometimes borrow against the accumulated equity in their homes to obtain funds to buy goods and services, to repay other debts, or to finance the purchase of financial or nonfinancial assets.

About half of the homeowners with mortgages refinanced at least once after buying their homes. Mortgage refinancing has become a widespread practice in recent years because of a combination of factors, including lower interest rates; the widespread adoption of new technologies that have reduced mortgage transaction costs; and gains in home values and equity, which have increased the opportunities to borrow additional amounts. In addition, the general disappearance of mortgage prepayment penalties during the late 1980s encouraged refinancing activity.

Refinancing activity tends to move inversely with changes in interest rates (chart 1). Because interest rates have fluctuated over the past decade or so and have been low relative to the previous two decades, homeowners have had several attractive opportunities to refinance in recent years. Relatively low long-term interest rates in the second half of 2001 and the first half of 2002 stimulated the most recent refinancing boom.

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The close link between mortgage interest rates and refinancing makes the time period under consideration important for estimating the amount of refinancing activity (table 2). Our survey asked detailed questions about refinancing during 2001 or the first half of 2002, a period of heavy refinancing activity. During this reference period, mortgage rates fluctuated considerably. As a consequence, the incidence of refinancing is dependent on the time frame within the full reference period. Between 16 percent and 23 percent of homeowners with mortgages reported refinancing since the beginning of 2001, depending on which period is considered (as shown in the memo item of the table). For the entire reference period, the 2002 survey findings suggest that an estimated 11 million homeowners refinanced their mortgages in 2001 or early 2002.