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 interest rate.
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 time--a 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 are falling.
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 refinancing.
