Mortgage refinancing in 2001 and early 2002

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

Refinancing lowered the interest rate of these mortgages to a dollar-weighted average of 6.8 percent. If the maturity and outstanding balance of the average refinanced mortgage had not changed, the decline in the interest rate would have lowered the monthly mortgage payment for the average refinancing homeowner by $98, for an annual savings of $1,179. Multiplying this annual savings by 11.145 million (the weighted 10.4 percent of the sample that refinanced over the period multiplied by an estimated 107 million households in the United States) yields an aggregate annual decline in mortgage payments of $13.1 billion.

The maturity of the average refinanced mortgage (again weighted by dollars of outstanding balance) was twenty-nine months longer than that of the average original mortgage. All else being equal, this lengthening of the maturity also served to lower mortgage payments. Allowing for both the longer maturity and the decline in the mortgage interest rate, the implied average reduction in the mortgage payment was $135 monthly, or $1,621 annually. This figure suggests an aggregate annual decline in mortgage payments due to both factors of $18.1 billion.

Offsetting the effects of lower interest rates and longer maturities on the mortgage payments of refinancers, outstanding balances rose by a substantial amount. The average homeowner who refinanced in 2001 and 2002 (including both those who cashed out and those who did not) reported that the cash received at settlement, after closing costs were paid, was $11,754. Adding this amount to the original mortgage balance, along with an additional 2 percent of the balance to proxy for closing costs (an amount commonly cited by industry analysts), the average outstanding balance after refinancing was $132,443. (9) The combined effect of the lower interest rate, the longer remaining maturity, and the higher balance is to lower the average refinancing homeowner's mortgage payments by $35 per month, or $418 per year, and aggregate annual mortgage payments by $4.7 billion.

Incorporating the associated change in income taxes reduces the savings achieved through refinancing. The estimated $4.7 billion reduction in aggregate mortgage payments represents the combination of a $6.7 billion decline in mortgage interest payments and a $2 billion rise in mortgage principal payments. The decline in mortgage interest payments implies that refinancers who itemize deductible expenses for calculation of taxable income were eligible for appreciably smaller deductions for interest payments and therefore had higher tax liabilities. Although the Survey of Consumers does not have enough information about the tax status of its respondents to allow for a precise estimate of the increment to tax liabilities associated with refinancing, we can do a rough calculation using data from other sources. In 1999, the ratio of home mortgage interest deducted by taxpayers ($272 billion) to total mortgage interest paid by homeowners ($328 billion) was 0.83. (10) This ratio suggests that the $6.7 billion decline in mortgage interest payments was associated with a $5.6 billion reduction in home mortgage holders' annual deductions. (11) In addition, federal income tax payments in 1999 were an estimated $56.9 billion lower than they would have been in the absence of the deduction for home mortgage interest payments. (12) Dividing this amount by mortgage interest deducted implies that the average marginal federal income tax rate of taxpayers deducting such interest was 21 percent in 1999. (13) Assuming that this marginal federal income tax rate applied to homeowners who refinanced their mortgages in 2001 and the first half of 2002 and further assuming that their marginal state income tax rate was 5 percent, the increase in tax payments associated with the refinancings would be $1.5 billion annually. Taking the difference between the aggregate annual reduction in mortgage payments associated with the refinancings and this figure implies that the additional tax liabilities would offset close to one-third of refinancers' aggregate annual savings from lower mortgage interest payments, putting aggregate annual savings net of income taxes at $3.2 billion.