The Effects of Recent Mortgage Refinancing

Federal Reserve Bulletin, July, 2000 by Peter J. Brady, Glenn B. Canner, Dean M. Maki

In recent years, rising home prices, generally falling interest rates, and a desire to convert accumulated home equity into spendable funds have combined to provide millions of homeowners with the opportunity and motivation to refinance the mortgage on their primary residence. In many cases, refinancing results in a lower interest rate and lower monthly mortgage payments, allowing homeowners to spend or save that portion of their incomes no longer dedicated to servicing mortgages. When they refinance, some homeowners liquefy the equity they have accumulated in their homes by borrowing more than they need to pay off their former mortgage and cover the transaction costs of the refinancing. They use the funds raised in such "cash-out" refinancings to make home improvements, to repay other debts, or to purchase goods and services or other assets.

The Federal Reserve Board closely follows refinancing activity as well as home equity lending, another form of borrowing used to liquefy accumulated equity in homes. Both topics have been the focus of Board-sponsored surveys of households and of previous articles in the Federal Reserve Bulletin.(1)

To learn more about the extent to which homeowners have been using refinancings to liquefy the equity in their homes and the way they have used the funds raised, the Federal Reserve sponsored questions concerning mortgage refinancing on the March through May 1999 Surveys of Consumers, monthly surveys conducted by the Survey Research Center of the University of Michigan (for details see appendix A). Such surveys are an important source of information on both the characteristics of a homeowner's mortgage and the homeowner's use of borrowed funds.

This article presents estimates, based on the survey findings, of changes in monthly payments resulting from refinancings, the amount of funds homeowners raised in the process, and how homeowners used the funds. Also presented are rough estimates of the aggregate effects of refinancing on the U.S. economy, including the effects on consumption spending.

THE DECISION TO REFINANCE

Choosing whether and when to refinance a home mortgage is an important and often difficult 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.

Balancing Costs and Benefits

In general, the question of whether to refinance arises whenever current interest rates on mortgages fall 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.(2) If the discounted present value of the stream of prospective after-tax savings in interest payments exceeds the after-tax costs of the transaction, the homeowner stands to gain from the transaction. The necessary calculations rely on certain assumptions, however, including assumptions about the course of future events, and thus the decision to refinance is often complex.

One assumption is the length of time the homeowner will own the property. If the property is sold relatively soon after a refinancing--because of a job relocation, for example--the savings in interest payments over time are unlikely to offset the costs of the transaction, unless interest rates had fallen rather substantially.

Another assumption is the homeowner's expectations about future interest rates. If the homeowner expects mortgage rates to decline, he may postpone the decision to refinance even when the benefit from refinancing exceeds its cost. The effects of uncertainty on refinancing may result in very different decisions, depending on the type of mortgage being refinanced. If the homeowner has a fixed-rate mortgage, expects mortgage rates to rise or fall with equal probability, and faces small potential savings, she may postpone refinancing because the certain gains are small, large gains are still possible if rates fall sharply, and no significant adverse effects will occur if rates rise sharply. If the homeowner has an adjustable-rate mortgage, however, the decision may be different. In that case, the prospect of higher future monthly payments should interest rates rise significantly may prompt the homeowner to refinance into a fixed-rate loan, even if the current savings are small. (Of course, a homeowner who keeps an adjustable-rate loan may reap the benefits of an interest rate decline without incurring the costs of refinancing, as the loan rate will ordinarily fall with market rates.)