Credit, Equity, and Mortgage Refinancings

TLDR: In this article, the authors consider the effect of individual homeowners' credit and property characteristics, such as personal credit ratings and changes in home equity, along with changes in mortgage interest rates, in the analysis and prediction of mortgage prepayments.

Abstract: Homeowners typically have the option to prepay all or part of the outstanding balance of their mortgage loan at any time, usually without penalty. However, unless homeowners have sufficient wealth to pay off the balance, they must obtain a new loan in order to exercise this option. Studies examining refinancing behavior are finding more and more evidence that differences in homeowners' ability to qualify for new mortgage credit, as well as differences in the cost of that credit, account for a significant part of the observed variation in that behavior. Therefore, individual homeowner and property characteristics, such as personal credit ratings and changes in home equity, must be considered systematically, along with changes in mortgage interest rates, in the analysis and prediction of mortgage prepayments. Early research into the factors influencing prepayments focused almost exclusively on the difference between the interest rate on a homeowner's existing mortgage and the rates available on new loans. This approach arose in part because researchers most often had to rely on aggregate data on the pools of mortgages serving as the underlying collateral for mortgage-backed securities (for example, see Schorin {1992}). More recent research, however, has broadened the scope of this investigation through the utilization of loan-level data sets that include individual property, loan, and borrower characteristics. This article significantly advances the literature on mortgage prepayments by introducing quantitative measures of individual homeowner credit histories to the loan-level analysis of the factors influencing the probability that a homeowner will refinance. In addition to credit histories, we include in the analysis changes in individual homeowner's equity and in the overall lending environment. Our findings strongly support the hypothesis that, other things being equal, the worse a homeowner's credit rating, the lower the probability that he or she will refinance. We also confirm the finding of other researchers that changes in home equity strongly influence the probability of refinancing. Finally, we provide evidence of a change in the lending environment that, all else being equal, has increased the probability that a homeowner will refinance. These findings are important from an investment risk management perspective because they confirm that the responsiveness of mortgage cash flows to changes in interest rates will also be significantly influenced by the credit and equity conditions of individual borrowers. Moreover, evidence overwhelmingly indicates that these conditions are subject to dramatic changes. For example, although the sharp rise in personal bankruptcies since the mid-1980s (Chart 1) partly reflects changes in laws and attitudes, it nonetheless suggests that credit histories for a growing segment of the population are deteriorating. Furthermore, home price movements, the key determinant of changes in homeowners' equity, have differed considerably over time and in various regions of the country. Indeed, in the early to mid-1990s home price appreciation for the United States as a whole slowed dramatically while home prices actually fell for sustained periods in a few regions (Chart 2). [Chart 1-2 ILLUSTRATION OMITTED] In short, as mortgage rates fell during the first half of the 1990s, many households likely found it difficult, if not impossible, to refinance existing mortgages because of poor credit ratings or erosion of home equity.(1) Consequently, the prepayment experience of otherwise similar pools of mortgage loans may vary greatly depending on the pools' proportions of credit- and/or equity-constrained borrowers. Our findings also contribute to an understanding of how constraints on credit availability affect the transmission of monetary policy to the economy (for example, see Bernanke {1993}). Fazzari, Hubbard, and Petersen (1988) and others have found that investment expenditures by credit-constrained businesses are especially closely tied to those firms' cash flows and are relatively insensitive to changes in interest rates, reflecting constraints on their ability to obtain credit. …