Mortgage refinancing - includes appendix on consumer attitude survey

Federal Reserve Bulletin, August, 1990 by Glenn B. Canner, Charles A. Luckett, Thomas A. Durkin

Mortgage Refinancing

This article was prepared by Glenn B. Canner and Charles A. Luckett of the Board's Division of Research and Statistics, and Thomas A. Durkin of the Office of the Secretary, with research assistance from Ian W. Burns and Wayne C. Cook. In recent years, homeowners have raised substantial amounts of funds for various purposes by liquidizing some of the equity in their homes. One means of doing so, and the main topic of this article, has been to refinance an existing mortgage for an amount greater than the outstanding mortgage balance plus closing costs.

In an earlier, we discussed the prevalence and use of home equity loans as another means of converting home equity to liquid form.(1) That report distinguished two types of such loans: "traditional home quity loans," which are closed-end loans thay typically require repayment of interest and principal in equal monthly installments, and the newer "home equity lines of credit," which are revolving accounts that permit borrowing from time to time at the discretion of the account holder up to the amount of the credit line. Using either type of home equity loan, homeowners are able to borrow against the accumulated equity in their residential property to finance the purchase of goods and services or to repay other debts.(2)

This article focuses on mortgage refinancing, particularly as it is used to tap accumulated home equity. To the extent possible, this report draws comparisons between those who increase their net borrowing by refinancing and those who do so through the use of home equity loans. Most of the material regarding refinancings presented here is drawn from a consumer survey sponsored by the Federal Reserve Board during mid-1989. (For a description of the survey, see the appendix.) Comparative information on the use of home equity loans comes from a consumer survey conducted in 1988.(3)

The Economics of Refinancing

Most discussions of the decision to refinance a home mortgage have concentrated on the case in which the existing principal is refinanced but no new borrowing is undertaken.(4) A homeowner faces the question of whether to refinance whenever current mortgage interest rates drop below the rate on the homeowner's existing mortgage. To determine the attractiveness of refinancing, homeowners must weigh the prospective aftertax savings from lower interest costs against the costs of the refinancing transaction itself, including any motgage fees (points), application and appraisal fees, and other costs associated with obtaining a new mortgage, as well as any prepayment penalty on the old mortgage. Because savings on interest accumulate gradually over time as scheduled payments are made, the amounts saved with each payment must be discounted to their present value by some appropriate rate, and their sum compared with the total cost of the refinancing. If the discounted present value of the stream of prospective after-tax savings in interest payments exceeds the after-tax refinancing costs, a homeowner might opt to refinance. However, several other considerations generally complicate the decision.

Cost Motivations Affecting the Decision

One consideration is the possibility that the homeowner might sell the property before the mortgage maturity date, thus reducing the total (and present value) of expected future interest savings. If the property were sold relatively soon after a refinancing, the savings in interest costs that had accumulated by that time would probably not offset the transaction costs associated with obtaining the new loan, unless the reduction in rate were unusually large.(5) This uncertainty about length of residence is one reason that most rules-of-thumb about whether to refinance incorporate the dictum that the costs of refinancing be recoverable within two years.

Uncertainty about the future course of interest rates also affects the refinancing decision. Seemingly, a homeowner should refinance whenever mortgage interest rates drop enough to generate a positive net saving on interest costs within a reasonable period of time. However, the timing of this decision is important because, if interest rates continue to fall, the homeowner will reap even larger savings by waiting to refinance. Thus, the decision to refinance depends on the homeowner's expectations about future interest rates weighed against the amount of savings available from an immediate refinancing, guided by the homeowner's willingness to forgo a known gain for the possibility of a larger one.(6) Generally speaking, if a rise in rates and a fall in rates of the same amount were viewed as equally likely, and the savings currently available from refinancing were relatively modest, the typical homeowner with a fixed-rate mortgage would probably choose to wait. The most that could be lost in the event of rising rates would be the relatively small savings currently available--a large rise in rates would have no more adverse effect than a small rise in rates. But a large drop in rates in the future would allow a large reduction in interest costs, so that the possible benefits of waiting to refinance would outweigh the possible costs. The situation is different if the homeowner has an adjustable-rate mortgage; in that case, the prospect of rising rates creates a greater incentive to refinance because it is possible for the rate on the existing mortgage to adjust to some level above the current one.