ST. LOUIS — Cash-out" refinancing has become popular with homeowners because it produces quick cash and usually leaves their monthly mortgage payments unchanged, but it can also create a greater burden of repayment down the road.
That analysis comes from William R. Emmons, a senior economist in the Federal Reserve Bank of St. Louis' Banking Supervision & Regulation Division. His comments appear in the July issue of The Regional Economist, the Reserve Bank's quarterly publication of business and economic issues. (The publication is also available online at the St. Louis Fed's web site: http://www.stlouisfed.org.)
The decline of long-term interest rates has spurred a huge surge in refinancing activity lately. While the number of households that refinanced their mortgages declined by more than 50 percent in the last year, 2004 still ranks near the top.
"Homeowners are faced with an array of refinancing options," said Emmons. "For example, they can shorten or extend the term of the mortgage. They can switch from a fixed rate to a floating rate or vice versa. They can choose to pay interest for a period of time, or interest and principal. The variety of options can be overwhelming."
To illustrate how complex the choices can be, Emmons uses the example of a household that plans to refinance an 8 percent, 30-year, $100,000 fixed-rate mortgage, after both expected inflation and mortgage rates have fallen 2 percentage points. The household will choose between simple refinancing and cash-out refinancing. Undertaking a simple refinancing, the homeowner would borrow $100,000 at 6 percent for 30 years with standard amortization (the amount of loan principal paid each month). This would reduce the monthly payment from about $734 to about $600.
By choosing the cash-out option, on the other hand, the homeowner would borrow about $122,386 at 6 percent (again, with standard amortization) and would maintain monthly payments at $734. The borrower would receive a check for $22,386, representing cash taken out by refinancing into a larger mortgage.
In this example, simple refinancing saves our homeowner $134 each month for as long as they keep the mortgage, while cash-out refinancing allows them to take home $22,386 in cash and keeps the monthly payments unchanged.
Emmons emphasized, however, that to accurately evaluate these options, the homeowner would need to consider "duration," a mathematical measure related to the speed at which debt is paid off. Duration is measured in years and takes into account the fact that interest and principal are paid at various points in time, not just at maturity. A key concept of duration is that for a given fixed-income instrument such as a mortgage, duration increases as rates decline, and vice versa.
"The 8-percent mortgage has a duration of 9.6 years, while the 6- percent mortgage has a duration of 10.8 years," said Emmons. "In other words, from today's perspective, half of the 8-percent mortgage will be paid off after 9.6 years, but it will take 10.8 years to pay off half of the 6-percent mortgage. The key point is that greater duration means a household should expect and plan for greater repayment burdens than previously expected, beginning at some future time."
Whichever refinancing option the homeowner chooses, the real economic burden of repaying the mortgage will not fall as steeply over time as would have been true with the original mortgage. The reason is that lower inflation implies that any fixed mortgage payment will not be eroded as quickly as before. In addition, with cash-out refinancing, the homeowner will face a higher real burden of repayment every month after the first one for the remainder of the life of the mortgage. Consequently, the cash taken out at refinancing is not "manna from Heaven," but, in effect, represents an additional loan that the homeowner will repay every month for the next 30 years, or until the mortgage is paid off.
Emmons said that that while mortgage refinancing is complex, that doesn't mean a household with a mortgage should not refinance when interest rates fall. "A household would be foolish not to do so if the present value of all the interest it can save is greater than the cost of refinancing," he said. "In practice, this usually means that mortgage rates do not need to fall very much to make refinancing worthwhile."
The trick, Emmons cautioned, is choosing how to refinance. "A lower inflation rate can push down mortgage rates, but it lowers the likely future growth of wage income and Social Security," he said. "Lower interest rates increase duration, which means that more of the real burden of repaying the mortgage automatically is shifted into the future." Emmons also noted that U.S. households last year were equally likely to engage in simple refinancing as they were in cash-out refinancing.
"Unless a household really needs the extra cash today," said Emmons, "cash-out refinancing may not be the best choice. Even though the monthly payments may remain the same, the increased mortgage principal represents a greater debt burden that must be repaid in the future."
With branches in Little Rock, Louisville and Memphis, the Federal Reserve Bank of St. Louis serves the Eighth Federal Reserve District, which includes all of Arkansas, eastern Missouri, southern Indiana, southern Illinois, western Kentucky, western Tennessee and northern Mississippi . The St. Louis Fed is one of 12 regional Reserve banks that, along with the Board of Governors in Washington, D.C., comprise the Federal Reserve System. As the nation's central bank, the Federal Reserve System formulates U.S. monetary policy, regulates state-chartered member banks and bank holding companies, and provides payment services to financial institutions and the U.S. government.