Mortgage refinancing - includes appendix on consumer attitude survey

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

Before the 1980s, virtually all refinancings involved the payoff of one fixed-rate mortgage with the adoption of a new fixed-rate mortgage. But the growth of adjustable-rate financing in the past decade has multiplied the possibile configurations a refinancing can have: A homeowner can also move from a fixed-rate loan to an adjustable one, from an adjustable to a fixed, or from one adjustable-rate loan to another.

The decision to refinance with an adjustable-or with a fixed-rate mortgage involves many of the same factors considered in the creation of the original home-purchase mortgage. Adjustable-rate mortgages (ARMs) are typically offerred with initial rates lower than those available on fixed-rate loans--sometimes with deeply discounted rates for the first year or two.(7) But, because the rate is adjustable, the borrower is exposed to increasing interest expense should rates rise, subject to the allowed frequency of adjustment and the limitations of any annual and lifetime caps on the mortgage rate. Expectations regarding future rates may thus play a key role in the homebuyer's opting for a fixed- or adjustable-rate loan initially or in a refinancing. In general, when rates are at the low end of the homebuyer's expectations, it makes sense to obtain fixed-rate financing, "locking in" the comparatively low rate. If rates are expected to rise sharply in the future, a homeowner with an ARM, as noted above, may choose to refinance into a fixed-rate loan (FRM), even when the new (fixed) rate is close to or above the rate currently in force on the ARM.

Expected length of residence may also be a crucial factor in deciding whether to refinance with an adjustable- or with a fixed-rate loan. As noted earlier, homeowners who expect to move very soon would probably not benefit from refinancing. However, those who plan to move within two years or so might find it optimal to refinance with an initially discounted ARM, since the brunt of an upward adjustment to higher market interest rates might not take effect until the move was imminent. Some homeowners might attempt a strategy of refinancing at regular intervals into initially discounted ARMs, assuming that such instruments continue to be offered.

Other Reasons to Refinance

Mortgage debtors may also elect to refinance for reasons other than obtaining lower interest costs on the existing principal. For example, liquidity-constrained homeowners might wish to reduce the size of their monthly payments, even if lower rates are not available. This reduction in monthly payments could be accomplished by refinancing for a longer term than the remaining life of the existing mortgage. Another reason to refinance, as noted, is to raise additional funds. In the household survey, nearly 60 percent of those who refinanced also borrowed additional funds. Many of these households obtained a lower rate than that on their old mortgage, but some accepted the same or a higher rate. The decision to raise new funds through refinancing hinges on the size of the existing loan relative to the amount of new funds sought, the comparative rates on the existing and prospective substitute loans, and the rates and terms available through alternative means of financing. If they can qualify for a refinancing, most homeowners, depending on the amount needed, will also be able to obtain funds using a home equity loan, a personal loan, or a credit card account. In most cases, a first mortgage carries the most attractive available rate, so that refinancing is often the best choice for raising a large amount of new funds. On the other hand, if the existing mortgage carries a very low rate and is large relative to the new funds required, a refinancing might best be avoided. The homeowner would probably not benefit by giving up the attractive old rate. Nonrate considerations also affect the decision. A home equity credit line, for instance, provides more flexibility for subsequent borrowing and might be more appropriate for handling repetitive credit needs, such as tuition expenses, even when rate comparisons seemed to favor a refinancing.