Refinancing

Owner-occupied housing is the major asset in many households’ portfolios and across a wide span of the life cycle. About two thirds of American families are homeowners. Housing wealth is an important determinant of consumption and saving behavior of households and is often correlated with savings and better overall financial management. A family's investment decision in housing may have profound implications for all those within it and for the economy at large. Investment in housing is often financed through a mortgage contract, a feature crucial for understanding the overall housing market. When a residential property is acquired, the new owner can either pay the full price—referred to as a full cash purchase—or pay a share of the sales price and borrow the rest on a mortgage. In the United States and other countries, the guideline for a mortgage has often been 80% or less of the market value of the property. Mortgages greater than 80% of the market value have often been subject to higher borrowing rates or other conditions.

The initial mortgage can have a wide range of features beyond the rate of interest. These include the term or years to scheduled payoff. Another is the option for the owner to end the contract without penalty. Combining a long payoff period with the owner option to end the initial contract and refinance with a fixed interest rate provides substantial financial protection for the owner against future inflation or periods during which income to support the mortgage payments is lagging. Historically, mortgages in the United States did not have long terms; many were set up to run only 6 years. With mortgages of 15, 25, and 30 years, there are far more opportunities and interceding factors that can motivate refinancing for a given owner.

[Page 589]Over time, as the payments in excess of interest costs are made, reducing the remaining principal balance of the mortgage, or, with price appreciation on the property, the owner will have growing home equity, the difference between the market price and the remaining balance on the mortgage. This equity can be accessed through various forms of refinancing. In refinancing, the outstanding mortgage balance is often increased, and the resulting cash can be used for a wide range of outlays—even to pay living expenses during a period of protracted unemployment or to pay for the children's college costs. This refinancing is referred to as refinancing up. Research supports the idea of such refinancing as primarily playing an important collateral or liquidity role for borrowing to support other expenditures. According to Eric Hurst and Frank Stafford, there are two motivations for exercising the option to refinance a mortgage. There is a traditional financial motivation to realize a net worth gain and possibly have an asset reallocation when exercising the option to refinance an existing mortgage at a lower interest rate. There can also be the motivation to refinance up and realize cash proceeds from the difference between the new larger mortgage and the prior mortgage principal. The motivation for exercising the refinancing up option to tap into equity and “borrow up”’ is often to support consumption. This can be seen from the fact that some homeowners will refinance their home even during a period when rates are higher. But when they do so, it is very often the case that they will increase the mortgage balance to get some cash from the transaction. Exercising this consumption option can lead to refinancing at a higher rate of interest. A third motivation to refinance can be to cover cash flow requirements from homeownership, which are induced by interest, tax, and utility costs. This refinancing can be thought of as a liquidity option—that is, refinancing to a position in housing that embodies a wider set of and higher level of costs. These are costs beyond those related to normal predicted consumption, based on income and family composition. This refinancing, often speculative, is based on expected appreciation, and it appears to have played a major role in the U.S. housing market turbulence from 2001 to 2009.

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