FRBSF Economic Letter
2003-29; October 3, 2003
One of the defining characteristics of the 2001 recession was the resilience
of consumer expenditures. Many commentators have pointed to the housing
market as one source of strength in consumption. This claim is usually
based on two observations. First, the combination of high homeownership
rates and low interest rates has allowed many households to refinance
to get more favorable rates and terms on their mortgages, adding a potentially
large amount to monthly disposable income. A homeowner who took out a
$150,000 mortgage at the height of the stock market boom in 2000 and refinanced
in July of 2003 saved $304 per month due to the declining cost of credit.
A second, and potentially more powerful, source of strength comes directly
from the increase in house prices. Mortgage lenders report that large
numbers of consumers not only refinanced to lower mortgage rates, but
also extracted equity from their houses by refinancing for larger amounts.
These developments in mortgage markets and mortgage refinancing are giving
researchers a renewed interest in homeownership and housing wealth and
their links to consumption over the business cycle. In this Economic
Letter, we review some of the research literature on the factors affecting
refinancing decisions, as well as some of the trends that have affected
mortgage markets and lowered the transaction costs associated with refinancing.
The refinancing decision
As with all economic decisions, the decision to refinance will depend
on the costs of refinancing and the expected proceeds from doing so. On
the cost side, it is important to note that the refinancing option is
valuable to a borrower and, thus, must be paid for. This cost can take
two forms. First, any refinancing results in the origination of a new
loan, which generates a set of fees. Second, borrowers may have to pay
a prepayment penalty. This cost can arise because, whenever it is advantageous
for borrowers to refinance at lower interest rates, it is also disadvantageous
for lenders to get their money back. Borrowers with no prepayment penalty
mortgages are presumably paying for this option in the form of a higher
The majority of the academic research by economists on mortgage refinancing
has focused on understanding why and when homeowners choose to refinance.
At heart, this should be a simple problem for households to solve: households
should compare the present value of the reduced mortgage payments over
the life of the loan to the cost of refinancing. Since the refinancing
cost is fixed in the short run, households should simply wait until interest
rates fall enough relative to their current rate, and then refinance.
Indeed, commonly cited rules of thumb, such as "refinance every time
the mortgage rate drops by 50 basis points," reflect this kind of
decisionmaking. But research has shown that households often delay refinancing,
even when it appears optimal to do so according to standard models (Stanton
1995). Evidently, a combination of future interest rate uncertainty (interest
rates could continue to fall), uncertainty about the duration of stay
in a house, and other borrower demographics are important determinants
of the refinancing propensity as well.
Bennett, Peach, and Peristiani (1998) study refinancing in the 1990s
and document some of the empirical facts of mortgage refinancing behavior.
All other things held equal, they show that households are more likely
to refinance when interest rate volatility is low, home equity values
are high, and creditworthiness is good. As early as the mid-1990s, they
note the structural changes in refinancing behavior over timea point
which has become increasingly apparent in the present day.
Another strand of the literature has examined the role of house value
in a household's wealth portfolio and how savings and consumption are
affected by this wealth. This is a relatively new area of research in
finance and macroeconomics that is receiving increasingly more attention
given the sheer size of housing in the portfolio. A house typically accounts
for one-third of total household wealth and nearly 70% of U.S. households
own their homes. When the head of the household is over 50 years old (i.e.,
households with the largest wealth), the homeownership rate is over 80%.
Krainer and Marquis (2003) model the mortgage contract in a dynamic setting
and trace out the implications of house price increases and interest rate
cuts on consumption through this channel. They show that the amount of
mortgage refinancing will depend not just on recent interest rate changes
or levels, but also on the whole history of interest rate changes and
levels. Refinancing activity also will depend on the history of house
prices. Refinancing will be tempered when housing demand is weak (defined
as a low rent, or low housing service flow value), even if interest rates
Hurst and Stafford (2002) use data from the Panel Study of Income Dynamics
to investigate how households use their housing wealth to smooth their
consumption. In particular, they show that housing wealth can act as a
hedge against adverse economic shocks. In the early 1990s, financially
constrained households suffering unemployment spells were 25% more likely
to refinance than less constrained households. The authors estimate that
refinancing households spent two-thirds of every dollar extracted from
Recent trends in mortgage refinancing
evidence on mortgage refinancing activity shows that the incentive to
refinance varies over time and has been especially strong in recent years.
Figure 1 plots the Mortgage Bankers Association Refinance Index against
the 30-year fixed rate mortgage from Freddie Mac's weekly survey. Changes
in the refinance index represent percentage changes in mortgage refinancing
applications from the previous month. A number of features quickly emerge
from the data. First, increases in the index are sharply concentrated
around local low points in the interest rate series. For example, at the
end of 1991, a brief downward spike was accompanied by a similar increase
in the Refi Index. Also apparent in the data is the short-lived nature
of changes in the refinancing index. Once interest rates dip to a point
where refinancing is profitable, households appear to refinance quite
quickly. When rates rise after hitting a low point, as they did in late
1998, refinancing completely dries up.
most obvious feature of Figure 1 is the enormous volume of refinancing
throughout 2000-2002a period overlapping with the most recent recession.
The differences in refinancing activity during this episode and the previous
recession help to illustrate some, but not all, of the factors affecting
the propensity to refinance cited earlier. It is clear that falling interest
rates alone will not necessarily trigger a boom in refinancing. Indeed,
in the early 1990s, interest rates fell by approximately the same amount
as they did between 2000:Q2 and the present day (approximately 4 percentage
points). But in the early 1990s, there was nothing like the current wave
of refinancing. One clear difference between the two periods is that house
prices remained flat during the 1990 recession, while they appreciated
strongly in 2000-2002 even as economic activity has slowed (see Figure
2), making it possible for households to extract built-up equity (see
Mattey and Wallace 1998 for evidence on the importance of house prices
in mortgage prepayment models, more generally).
But even taking into account the traditional determinants of households'
propensity to refinance, the figure suggests that something else has happened
to increase the rate of refinancing. This may be due to technological
change on the cost side. Credit scoring models have reduced the time it
takes to determine whether borrowers qualify for loans, enabling them
to take advantage of interest rate moves more quickly. Other improvements
in information processing have chipped away at the fees associated with
originating the new loan. For instance, some mortgage lenders will waive
the appraisal fee for existing customers on straight rate and term refinancings.
Finally, the improved search capabilities brought by the Internet have
increased competition. The ability of consumers to compare refinancing
costs has never been better.
Quantifying the extent of mortgage refinancing and the uses of cash-outs
is difficult due to the limited amount of information on what households
have done with their gains from refinancing. An important glimpse at the
economic impact of refinancing can be found in research by Canner, Dynan,
and Passmore (2002). Using survey data, the authors estimate that U.S.
homeowners saved an annual $4.7 billion in mortgage payments (net of increases
in loan principal) through refinancing and $131 billion in cash-out refinancing
in 2001 and early 2002. The majority of the funds raised through cash-outs
was used for home improvements, consumption expenditures, and the restructuring
of existing household debt. The authors estimate that cash-out refinancing
could have added as much as one-half percent to aggregate personal consumption
expenditures in 2001.
Of course, the wave of cash-out refinancing has resulted in many households
increasing their debt levels. In the October 2002 Senior Loan Officer
Survey, which covers approximately 60 domestic and foreign banks, one-half
of the respondents reported that between 20% and 40% of their customers
refinanced for more than the outstanding principal. The majority of banks
reported that the typical increase in principal was in the 5%-15% range.
The current refinancing boom is interesting because it appears to represent
a structural change in the economy. If technological change has caused
refinancing to become cheaper, then two important implications follow.
First, houses must have become more valuable assets, for now they are
more easily pledged as collateral. Second, adverse economic shocks to
household wealth now could be easier to absorb since home equity can more
easily be tapped in order to smooth consumption.
Professor of Economics, Florida State University
[URLs accessed September 2003.]
Bennett, P., R. Peach, and S. Peristiani. 1998. "Structural
Change in the Mortgage Market and the Propensity to Refinance."
FRBNY Staff Report 45. http://www.ny.frb.org/rmaghome/staff_rp/sr45.html
Canner, G., K. Dynan, and W. Passmore. 2002. "Mortgage
Refinancing in 2001 and Early 2002." Federal Reserve Bulletin (December),
pp. 469-481. http://www.federalreserve.gov/pubs/bulletin/2002/02bulletin.htm#dec
Federal Reserve Board of Governors. 2002. Senior
Loan Officer Survey on Bank Lending Practices.
Hurst, E., and F. Stafford 2002. "Home Is Where
the Equity Is: Mortgage Refinancing and Household Consumption." Forthcoming
in Journal of Money, Credit and Banking.
Krainer, J., and M. Marquis. 2003.
"Mortgages as Recursive Contracts." FRBSF Working Paper
Mattey, J., and N. Wallace. 1998. "Housing
Prices and the (In)stability of Mortgage Prepayment Models: Evidence from
California." FRBSF Working Paper 98-05. http://www.sf.frb.org/econrsrch/workingp/wp98-05.pdf
Stanton, R. 1995. "Rational Prepayment and the
Valuation of Mortgage-Backed Securities." Review of Financial Studies
8(3), pp. 677-708.