U.S. Economic Outlook: August 2018

Refinance in a Rising-Rate Market

By Frank Nothaft Housing Affordability, Mortgage Finance

Interest rates on fixed-rate mortgages hit 4.6 percent in May, the highest rates in seven years.  The rise in rates triggered a significant slowdown in refinance but not a stoppage.  The needs of homeowners who refinance in an environment of rising rates is different from the ‘rate-and-term’ borrower that dominates during a refinance boom triggered by low rates. 

Cash Out Refinancing Reemerging

The share of refinance loans that cash-out some home equity is generally very small during a refinance boom.  During 2012, when 30-year fixed-rates fell to an all-time low, the cash-out share of refinance fell to 10 percent, the lowest recorded in CoreLogic’s public records data during the last two decades (Figure 1).[1]  When rates have gone up, there are fewer homeowners who refinance to obtain a lower interest rate, and the cash-out share rises.  This year is on pace to have a cash-out share of about 40 percent, the highest since 2005.

As Rates Rise Refiers Keep or Lengthen Term

Homeowners that obtain a cash-out refinance when rates are at or above the rate on their prior loan may choose a term of up to 30 years on their new loan to keep the change in their monthly mortgage payment as small as possible.  Thus, in a rising rate environment, the percent of borrowers who lengthen their loan term at refinance tends to increase.  During 2012, only 13 percent of borrowers who refinanced their 15-year loan chose a longer-term loan (Figure 2).  But as rates rose during the first quarter of 2018, 43 percent of those refinancing their 15-year note took a loan with a longer term.

When Rates Rise Refi Credit Scores Fall

Further, some homeowners who may have blemishes in their credit history, or had insufficient home equity to refinance when interest rates were lower, are additional refinance candidates when rates and home equity have increased.  When refinance applications are less, lenders may have more resources to work with prime-credit applicants that require additional documentation.  Generally, the average credit score dips about 10 points for refinance borrowers when mortgage rates have risen by 0.6 percentage points (Figure 3).

In contrast to the ‘rate-and-term’ refi typical during a refi boom, refinance borrowers in a rising rate environment often choose to cash-out some home equity, obtain a longer term, and may have somewhat lower credit scores. 

[1] CoreLogic defines a refinance as a ‘cash-out’ if the principal amount of the new loan is at least 5 percent or at least $5,000 greater than the origination principal of the paid-off loan. 

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