Mortgage refinancing.

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.

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.

RESULTS OF THE BOARD'S CONSUMER SURVEY

To obtain information about mortgage refinancing the Federal Reserve Board sponsored a survey of households in 1989. In total, the survey included a nationally representative sample of 1,514 families. The following sections present the results of the survey.

Prevalence of Refinancing

Nationwide, the consumer surveys show that roughly 67 percent of all households own their homes, a figure consistent with Census Bureau statistics. The majority of these homeowners have an outstanding mortgage obligation on their lower initial cost to accept the risk of a higher future cost. Sometimes, as a stronger inducement for the borrower to choose an ARM, the lender reduces the initial rate even below the level implied by the index-plus-margin formula; these initially discounted rates are popularly known as "teaser rates." In the past two years, roughly 60 percent of ARMs originated carried an initial rate discount. primary residence (table 1). However, there is considerable regional variation in the holding of such debt. For example, two-thirds of the home-owning families in the Western region of the country have mortgage debt, while only half of those in the South and in the North Central region have such an obligation. There is also considerable variation across regions in the proportion of mortgage debt holders who have refinanced their home loans. Nationally, one-fifth of all mortgage debt holders have refinanced their first mortgage. However, the proportion of mortgage debt holders who have refinanced ranges from a low of 13 percent in the South to slightly more than 25 percent in the Northeast and Western regions.

The overall proportion of mortgage debt holders who have refinanced their primary mortgage has increased markedly over the past decade or so. Results from the 1977 Survey of Consumer Credit indicate that as of 1977 only 8 percent of homeowners with first mortgage debt had refinanced, well below the current figure of 20 percent.[8] This change in the prevalence of refinancing activity over time undoubtedly reflects the greater swings in interests rates in the period since 1977, which have presented more opportunities for homeowners to benefit from refinancing, and also reflects the availability of more home equity, created in substantial part by rapidly rising house prices during the late 1970s and portions of the 1980s.

The effects of interest rate levels on the volume of refinancing are illustrated in table 2, which shows the percentage distribution of refinancing by the year of the refinancing for the families surveyed in 1989. Relatively few homeowners refinanced during the early 1980s, when mortgage rates were well into double-digit figures. However, refinancing activity picked up in the mid-1980s and was especially strong in 1986 and 1987, when interest rates were substantially lower than in previous years. Aggregate data on refinancing activity, which are available only for thrift institutions and for loans guaranteed by the Veterans Administration , show a similar pattern (chart 1). In both cases, refinancing accounted for a much larger portion of loan originations in 1986 and 1987 than in other years. In 1986, for example, nearly half of all mortgage loan originations (measured in dollars) at thrift institutions were refinancings.

As noted, roughly 20 percent of all mortgage debt holders have refinanced their first mortgage loan. However, the proportion of total first mortgage debt outstanding accounted for by these refinanced loans is about 23 percent. The share accounted for by refinancing is larger in terms of the amount of total debt because many of the refinancings involved additional borrowing, and most of the refinanced mortgages were more recent in origin, and therefore larger, than the average of all loans outstanding. The evidence suggests that refinanced loans include a heavy concentration of loans replacing ones originated in the early 1980s, while the total stock of mortgage debt includes many loans made earlier when house prices were lower.

Sources of Refinancing and Home Equity Loans

Homeowners have refinanced mortgage debts through a wide range of financial institutions, although commercial banks and savings institutions (savings and loan associations and savings banks) have been the predominant sources of funds (table3). Other creditors, such as mortgage and finance companies, also have a significant market share, together accounting for about one-quarter of the refinancings. This division of the market is similar to that for traditional home equity loans. In contrast, finance companies and other nondepositary sources of credit play a much smaller role in the market for home equity lines of credit.(9)

Reasons for Refinancing

As discussed earlier, consumers who refinance may do so for two very different reasons, although in some instances both reasons may be motivating factors. For some mortgage debt holders, the sole motive to refinance is to reduce the payment burden of the existing debt, either by obtaining a lower interest rate or by extending the term of the loan.(10) For other homeowners, the decision to refinance reflects primarily a desire to extract accumulated home equity in order to finance the purchase of goods and services, including additional real estate, or to repay other debts.(11) Of course, some homeowners who refinance and liquidize equity may also be influenced by the opportunity to obtain more attractive rates than the ones on their existing mortgage loans.(12) Consumer responses to the Board-sponsored surveys are consistent with these broad motivational distinctions. Eighty percent of those who refinanced but did not simultaneously liquidize equity mentioned more attractive credit terms (mainly lower interest rates) as their motive to refinance. On the other hand, fewer than half of those who liquidized equity cited better terms as a motive to refinance. Thus, it appears that the majority of those who liquidize equity in the course of refinancing are motivated primarily by the opportunity to extract equity from their homes rather than by the opportunity to obtain better financial terms on their new versus old mortgage loan.

Comparisons with the results of Board-spronsored consumer surveys in 1988 suggest that those who refinance to mobilize equity use their "extra" borrowed funds in much the same manner as those who have obtained home equity loans (table 4). For both groups the two most frequent uses of borrowed funds are to finance home improvements and to repay other debts. The latter motivation has likely become particularly important in recent years because the Tax Reform Act of 1986 has largely eliminated the deductibility of interest paid on nonmortgage consumer credit. The purchase of real estate is another fairly common use of both hom equity loans and extra funds obtained during a refinancing.

Adjustable- and Fixed-Rate Refinancing

Among the refinancing transactions studied in the survey, slightly more than 80 percent of the original loans had fixed rates (table 5), roughly the same proportion of FRMs as among all mortgages surveyed. Sixty-five percent of all refinancings involved payoff of one FRM with another FRM, and 13 percent of the cases involved a switch from an ARM to an FRM. The large number of refinancers that opted for fixed-rate financing is not surprising insofar as borrowers tend to refinance when rates are perceived as low, and the inclination is to lock in low rates with fixed-rate loans. Still, 17 percent of those who refinanced switched from a fixed-rate loan to an adjustable one. These "fixed-to-adjustable" refinancers seemed to divide into two main groups. About half had relatively small balances remaining on their original mortgages, oftenwith a very low interest rate, and they borrowed substantial amounts of new funds. In these cases, the primary objective was clearly to raise new funds. Refinancing an existing mortgage was apparently the cheapest way to do it, notwithstanding the sacrifice of the low rate on the old balance. The other half refinanced fairly large balances, in most cases with cost reduction as a key objective. Many of these refinancers were apparently attracted by big initial rate discounts: Their refinancings were generally recent (in 1986 or later), and the initial rate after the refinancing was substantially below the current rate, although interest rates generally have not risen much since 1986. Interestingly, the current rate in most of these cases was still at least somewhat below the rate on the original fixed-rate loan.

Amount Borrowed When Liquidizing Equity

On average, consumers who liquidize equity during refinancings borrow about 25 percent of their accumulated equity. For some refinancers, the amount of extra funds borrowed can be quite large. For those who borrowed additional funds during refinancings between 1986 and September 1989, 15 percent obtained more than $25,000 (table 6). The mean and median amonts of extra funds borrowed were $25,145 and $15,941 respectively. These amounts were about the same as for homeowners who borrowed through traditional home equity loans during a similar time period. The mean and median for the latter were $22,534 and $15,905 respectively.

Regional Pattern of Equity Extraction

As noted above, nationwide, nearly 60 percent of those who refinanced their first mortgage liquidized some equity (table 7). The sample size is too small to draw strong conclusions about regional patterns, but the limited evidence suggests that borrowing additional funds through refinancing may have been more common in the Western and Northeastern regions of the country. If so, this regional pattern would be similar to the one that holds for the use of home equty credit: The proportion of mortgage debt holders with a home equity loan in the Northeast is more than twice that pertaining in the South or in the North Central region. Use of home equity loans is also higher in the West thatn in these latter two regions, although by a much smaller margin.

These regional variations in refinancing activity appear mainly to reflect underlying differences in the levels of home equity in the different sections of the country. Among the regions, both the Western and Northeastern areas have had relatively raped appreciation in house prices over the pasr several years, although prices in the Northeast have softened recently. From the beginning of 1985 to the time of the survey in 1989, average prices on sales of existing homes rose 43 percent in the Northeast and 27 percent in the West, as compared with 14 percent in the South and 20 percent in the North Central region.(13)

SUMMARY AND CONCLUDING OBSERVATIONS

The two major reasons that homeowners refinance the mortgages on their homes are to reduce their debt-servicing costs by obtaining a lower interest rate or to raise additional funds by increasing the principal owed. These reasons are by no means mutually exclusive, of course; those who raise new funds may be motivated by an opportunity to lower the interest rate as well. In the survey discussed here, about 60 percent of the refinancers interviewed had borrowed additional funds in the process of refinancing. Homeowners contemplating new borrowings have several alternatives to consider besides refinancing an existing mortgage. They can also tap the equity in their homes by taking out a traditional closed-end and second mortgage or by obtaining a revolving home equity line of credit. Survey data indicate that these latter alternatives have been the more frequently chosen means of extracting equity in recent years. In one survey, 7 percent of all homeowners had a refinanced mortgage that involved the raising of additional funds; in another survey, about 11 percent of homeowners had a home equity loan of one type or the other. Whatever the means of borrowing against home equity, the surveys indicate that the principal uses of the additional funds are the same: namely, to finance home improvements and to repay other debts. Also, the additional amounts borrowed through refinancing, roughly $25,000 on average, appear similar in size to the amounts owed on traditional home equity loans, and somewhat larger than the average balances owed on equity-secured lines of credit.

The ability to borrow against accumulated home equity provides homeowners with a means to reduce liquidity constraints on their consumption patterns; that is, it enables them to tailor expenditures to current needs in light of expectations about their income and asset holdings over the long term. The generally lower cost of borrowing against home equity compared with other types of financing suggests some positive effect of its availability on total consumption. However, insofar as most research has found consumption to be determined principally by income, the availability of home equity credit likely affects the timing of a household's consumption more than its total over a lifetime.

Overall refinancing activity in coming years will depend in an important way on movements in interest rates, is it always has. Unless mortgage interesrt rates drop substantially or exhibit wider swings in the next few years than they have since the mid-1980s, the incentive to refinance as a cost-reducing measure will probably be muted in the near to medium term. However, refinancing to raise new funds, as well as borrowing through home equity loans, could be expected to grow proportionately with general economic activity. Although more sluggish increases in real estate values recently may damp consumer appetites for liquidizing equity and may influence creditors to lend more cautiously, the amount of untapped equity in the country remains substantial and growing.

APPENDIX: SURVEY OF CONSUMER ATTITUDES

To obtain information on the prevalence of residential mortgage refinancings by homeowners and the extent to which refinancings are used to liquidize accumulated equity, the Federal Reserved Board sponsored questions that were included in the Survey of Consumer Attitudes for the months of June, July, and September 1989. The Survey Research Center at the University of Michigan conducted by telephone, with telephone numbers chosen from a cluster sample of residential numbers. The sample was chosen to be broadly representative of the four main regions--Northeast, North Central, South, and West--in proportion to their populations (Alaska and Hawaii were not included). For each telephone number drawn, an adult from the family was randomly selected as the respondent. The survey defines the family as any group of persons living together who are related by marriage, blood, or adoption, and any individual living alone or with persons to whom the individual is not related.

Together the surveys sampled 1,514 families, 1,050 of whom were homeowners. Among the homeowners, roughly 54 percent had an outstanding mortgage or land contract. Overall, 114 homeowners reported that their outstanding first mortgage was a refinanced loan. The survey data have been weighted to be representative of the population, thereby correcting for differences among families in the probability of their being selected as survey respondents. All statistics in the tables are based on weighted observations. Estimates of population characteristics derived from samples are subject to errors based on the degree to which the sample differs from the general population. Table A.1 indicates the sampling errors for proportions derived from samples of different sizes. [Tabular Data 1 to 8 Omitted] [Chart 1 Omitted]

[1]Glenn B. Canner, Charles A. Luckett, Thomas A. Durkin, "Home Equity Lending," Federal Reserve Bulletin, vol. 75 (May 1989) pp. 333-44. [2]Of course, a fourth method of extracting equity is to sell the property and either purchase a lower-priced home or rent. [3]See Canner, Luckett, and Durkin, "Home Equity Lending." [4]For examples, see John Marquardt and Walt Woerheide, "Mortgage Refinancing: A Better Decision Rule and the Impact of Tax Reform," Journal of Retail Banking, vol. 10, (Fall 1988), pp. 23-31; Jeremy J. Siegel, "The Mortgage Refinancing Decision," Housing Finance Review, vol. 3 (January 1984), pp. 91-97; Arefaine G-Yohannes, "Mortgage Refinancing," Journal of Consumer Affairs, vol. 22 (Summer 1988), pp. 85-95. [5]The closing costs associated with a refinancing are generally treated as a front-end, lump-sum cost. Although these closing costs are frequently added to the balance owed on the new loan, the present value of the payments associated with financing the closing costs is essentially equal to a lump-sum payment if the discount rate applied is equal to the interest rate on the new loan. A small difference between the two amounts may exist, however, owing to tax effects. If the closing costs on a refinancing are financed, the interest paid on those borrowed funds is fully tax deductible. On the other hand, if a lump-sum payment of closing costs is made, only the portion of the closing costs that constitutes points (pre-paid interest) is tax-deductible, and it must be amortized over the life of the loan. [6]The option of a rapid sequence of refinancings as rates decline is generally not feasible because prepayment penalties and mortgage fees make it too costly. [7]On most ARMs, the interest rate is set in reference to some "index" rate determined by market forces, such as the yield on one-year Treasury securities. A markup over the index rate, the "margin," is also specified in the contract. The mortgage rate, calculated as the index rate plus the margin, is reset from time to time, frequently at one-year intervals. Rate adjustments are usually subject to certain limitations: Most ARMs contain "caps" on how much the rate may rise in a year and over the life of a loan; annual caps of 2 percentage points and lifetime caps of 5 percentage points are common. The initial rate on an ARM is virtually always lower than the rate on a fixed-rate loan of comparable maturity and loan-to-value ratio. The lower rate reflects the fact that much of the "interest rate risk" of long-term loan contracts is shifted from the lender to the borrower in an ARM transaction. The borrower needs the incentive of a lower initial cost to accept the risk of a higher future cost. Sometimes, as a stronger inducement for the borrower to choose an ARM, the lender reduces the initial rate even below the level implied by the index-plus-margin formula; these initially discounted rates are popularly known as "teaser rates." In the past two years, roughly 60 percent of ARMs originated carried an initial rate discount. [8]Thomas A. Durkin and Gregory E. Elliehausen, 1977 Consumer Credit Survey (Board of Governors of the Federal Reserve System, 1978) p. 92. [9]See Canner, Luckett, and Durkin, "Home Equity Lending" table 1, p. 335. [10]In addition, some consumers may elect to refinance an adjustable-rate mortgage with a fixed-rate loan, even without a lower rate, in order to eliminate the risk of future increases in payments. [11]In a recent paper, Manchester and Poterba found a negative correlation between the occurrence of a refinancing and changes in net worth. This suggests that, on average, a portion of equity liquidized during refinancings is used for consumption rather than investment purposes (reinvesting liquidized equity would leave net worth unchanged), although it could reflect portfolio adjustments made in response to declines in the value of other assets. See Joyce M. Manchester and James M. Poterba, "Second Mortgages and Household Saving," Regional Science and Urban Economics, vol. 19 (May 1989), pp. 325-46. [12]In some cases homeowners need to refinance to repay the balance due on a short-term mortgage. Such loans, commonly referred to as balloon mortgages, typically incorporate periodic payments based on a relatively long amortization period, but with a lump-sum principal payment due in the near term, typically five years. Such loans are the standard method of financing home purchases in Canada but are relatively rare in the United States. [13]"Home Sales," Monthly Reports (1985-89), National Association of Realtors, Economics and Research Division, Washington, D.C.