Households Refinance Their Mortgages

Home mortgage and home equity credit is the cheapest form of consumer credit available (except parents). Why? Over the period from 2000 through January 2003, the average effective rate on 30-year fixed rate home mortgages has ranged from 7.52 percent (average: 2000) to 6.12 percent in January 2003. Second, interest payment may be tax-deductible expenditures. Third, as inflation raises the market value of the home, the size of the available loan rises, thus providing a hedge against inflation. Finally, since the homeowner and lender already have a relationship, transaction costs are typically less than applying for a loan elsewhere. As these advantages prompt more homeowners to shift more of their borrowing to some form of mortgage or home equity product, other lenders are increasingly left with the market for non-homeowners, which may involve a higher cost and credit risk. This has some interesting implications for non-mortgage lenders in the coming years, and also explains why so many companies that formerly did not do home equity lending (e.g., Household International; MBNA) have entered that market.

Not only is mortgage credit less costly than other forms of credit available to consumers, but its cost has been declining in recent years. Over the period shown in the table below, average effective interest rates on residential mortgages fell 7.52 percent to 6.12 percent. Refinancing a home mortgage allows borrowers to take on additional debt, as well as lower their interest costs. In the first quarter of 2002, 61 percent of Freddie Mac-owned loans that were refinanced resulted in new mortgage loans at least five percent higher than the original amount borrowed. In a very real sense, homeowners own a "bank"-that is, their home. The home provides collateral for the loan that can be obtained with minimal effort, since the lender and homeowner have already established a satisfactory relationship. Furthermore, the interest expense is tax-deductible. On top of that, the value of homes has grown by more than 7 percent just in this past year.