Friday, February 1, 2013

Some (un)intended consequences of mortgage refinancing

As mortgage rates are decreasing and households take on mortgages with lower rates there are several consequences, not all of them obvious.

The amount of interest paid, C.P goes down which at first glance is a good thing. The consumer now has the option to allocate the difference between the old and the new payment to other purposes. The downside of lower payments is that somebody else is now receiving less, and likely that somebody else is a pension fund, life Insurance Company or another entity which needs long dated cash flows. Chances are that as the homeowner refinances the NPV of his/her pension or insurance decreases at the same time. The economic effect of the increased cash flows to the household sector and the decreased cash flows to pension funds, life insurance companies et al. is not symmetrical because the household sector has a high marginal propensity to consume – they spend most of the savings – whereas the financial savings institutions buy financial assets (in other words, they save).

Another aspect of refinancing, and the generally lowering of interest rates on mortgage debt is less obvious though which is worth looking at.

Assuming a 100,000 mortgage for 30 years at 8% the monthly payment is 733 of which (for the first month) 666 is interest, 67 is principal and therefore the initial ratio of interest to principal (I/P) is 9.9. When that mortgage gets refinanced to 4% the payment decreases to 477, interest is 333 and principal is 144 so the I/P ratio goes to 2.3.

This means that the homeowner in a lower rate environment builds equity much, much faster which means that it has a positive effect on household net worth even if the reduction in payments is completely consumed.  If homeowners were to take the monthly savings in interest and use it to prepay their mortgage the equity build would be even faster. The flip side is of course that the holder of the mortgage has reduced interest income and an increased principal flow which needs to be reinvested. At the same time the total monthly cash flow to be invested (presumably in financial assets) by the mortgage holder goes down).

As the amount of interest paid by the household sector decreases so does the tax deduction they receive on this. In other words, the lower the interest paid by the household sector the higher their effective tax rate, c.p.. That means that although rate reductions lead to an increased ability to consume, it is less than 100% of the interest savings, and tax revenues increase.

Another consequence is that as total monthly payments go down the servicing fees servicers receive decrease as well. Generally servicing fees are a fixed percentage of the monthly payment so less dollars flow into the financial sector. Similarly, as rates fall the interest rate exposure which needs to be hedged by parties who want to neutralize interest rate risk also is reduced. This is because as rates go down the dollar value per basis point also shrinks, and leads to reduced dollar weighted interest rate hedging transaction.

The overall this aspect of lower rates, a policy with the initial intention to rescue the financial sector and secondarily to increase aggregate demand, may have the (unintended?) effect of transferring wealth from the financial sector to the household sector and the government.