May 2003
By ROBERT PEGG
A recent study has concluded that the recent boom in mortgage refinancing has accounted for 20% of the growth in the nation's gross domestic product over the past two years.
Approximately $1.2 trillion of mortgages were financed in 2001 and analysts say that between $1.2 trillion and $1.4 trillion will be financed in 2002, according to Economy.com, a Philadelphia-based economic consulting firm. The current mortgage refinancing boom is without precedent. Since it began two years ago, close to $2.5 trillion in mortgage debt has been refinanced, equal to about 40% of all mortgage debt outstanding. By comparison, the previous refinancing record was set in 1998 when about $800 billion in mortgage debt was refinanced.
Fueling the boom in refinancing has been the dramatic decline in mortgage rates, with fixed-rate mortgages dropping to a 40-year low of close to six percent and rates on adjustable mortgages falling to about four percent. Mortgage transaction costs also have declined substantially. With mortgage rates falling so significantly, a large number of homeowners have found that the after-tax cost savings on a new lower-rate loan are much greater than the transaction costs involved with the refinancing. Virtually all of the mortgage borrowers have recouped the transaction costs involved in the refinancing from the lower monthly payments within one year of the refinancing.
Helping to solidify the soaring refinancing activity has been the very strong gains in housing prices. Given booming demand in many parts of the nation, the value of housing has soared close to $5 trillion in the past five years. The average homeowner has experienced more than a $70,000 increase in the value of their houses since the late 1990s. Moreover, homeowners have become more willing and able to tap the higher equity in their homes through cash out refinancing. Cash out refinancing occurs when borrowers increase their mortgage balances by more than the transaction costs involved in the refinancing. Freddie Mac estimates that well over one half of refinanced mortgages over the past two years have been cash outs in that the new mortgage balances have been more than five percent greater than the original balance.
The present refinancing boom is occurring all across the nation. But the most significant activity has been between Washington, D.C. and Boston and on the West Coast. Long Island, NY has experienced almost a six-fold increase in refinancing activity in the past two years. Other metropolitan areas that have benefited include Minneapolis, Miami, Orlando and Chicago.
Another important point to note is that mortgage borrowing has become an increasingly attractive method for raising cash, given that credit card interest rates have remained relatively high. According to the Federal Reserve Board, interest rates on credit cards on average have fallen only from about 16 percent to 13 percent over the past few years. Given that mortgage interest payments are tax deductible, and credit card interest payments are not, the financial advantages of mortgage borrowing are clear. In 2002, outstanding credit card debt experienced one of its slowest growth years on record.
The benefits for the economy have been obvious. According to Fannie Mae, more than one-half of the cash being raised is being used to directly finance more spending by consumers. This spending includes everything from home improvements, automobile purchases, vacations, education and medical expenses. In addition, close to one-third of the cash raised in the cash outs are being used to pay other installment debt and even second mortgage debt. Refinancing households are saving an estimated $10 billion in annual interest payments on their mortgage and consumer installment liabilities.
Economists worry over the potential for heightened credit risk posed by the increased mortgage debt loads of cash-out borrowers. Households have come under increasing financial stress from erosion in the various measures of mortgage credit quality. Moreover, the refinancing boom could moderate if mortgage rates begin to rise. However, even if they do, the economic benefits of the current wave of refinancing activity should linger. Homeowners with lower monthly mortgage payments will be able to spend more of their budgets on consumer items. With two-thirds of the economy based on consumer spending, that is a positive note for an otherwise shaky economic outlook.
About the author: Mr. Pegg is president of Kirkbride Asset Management, the New York City-based investment advisory firm which serves businesses, institutions and private individuals.