There are two types of refinancing, cash-out refinancing and rate refinancing. These constitute the largest source of prepayments.
Cash out refinancing
These types of refinancing are not sensitive to economic incentives to prepay such as lower mortgage rates. Regardless of the direction of rates the borrower will choose to refinance. There are two principal reasons for his doing so. Firstly it is to realize the equity in his home due to house price appreciation and the effect of amortization on his loan balance. The second reason is a process of debt consolidation. If the homeowner believes that the new mortgage, though having a contract rate higher than his existing mortgage rate, offers an opportunity of him making lower overall interest payments as compared to his current combination of interest payments on account of mortgage, credit card debt, student loans, etc, he would be more likely to opt for a cash-out refinancing opportunity.
Modeling this factor usually entails tracking how house prices appreciate for mortgages in the pool over time.
A borrower will avail rate refinancing when the mortgage rates in the market are lower than those he is currently paying. He will refinance out of his existing loan and into a new one having a lower contract rate.
However the rate advantage differs for each borrower and a borrower will only choose to refinance if the savings obtained by refinancing are greater than its hypothetical transactions costs. The factors that play in the decision to refinance include:
- Loan size: The larger the loan balance the greater the incentive to refinance when rates fall as there is a greater potential cost savings.
- Points paid effect: The lower point or no point borrowers will be more likely to refinance when rates fall as compared to high-point borrowers and will have a steeper seasoning ramp.
- Rate premium: If the mortgage has been issued at a premium to a benchmark rate it is usually an indicator of the impaired credit quality of the borrower. This impairment acts as disincentive to refinance.
- Threshold media effect: Another factor that plays an important role in the decision for a borrower to refinance is how the current lower rates compare with historical rates. If the borrower believes that there is a potential for rates to go down further below historical thresholds he will hold back on refinancing now to take advantage of potential lower rates in the future. If rates are believed to have crossed historical lows, refinancings increase significantly further encouraged by increased media publicity pertaining to refinancing solicitations. As the mortgage rates continue to fall the prepayments will begin to level off as only those borrowers who are the most refinancing impaired remain in the pool, this is known as the burn out effect.
- Loan to Value Ratio: Certain mortgages required that LTV be within a certain range to qualify for refinancing. If the LTV exceeds this maximum then the borrower cannot qualify for refinancing or will face higher transaction cost because of the low equity in his house. However as house prices appreciate it is possible that the LTV ratios improve making these borrowers eligible. These borrowers are more likely to respond aggressively to such opportunities.
- The yield curve slope term: this reflects the refinancing sensitivity to move from conventional mortgage types to alternate hybrid types that allow the borrower to take advantage of the slope in the yield curve, in particular the shorter end of the yield curve.
The refinancing incentive is usually modeled as the ratio of the borrower’s loan rate to the current rates. In order to calculate this ratio the current mortgage rates have to be projected/ simulated. The mortgage rates are usually expressed as a function of the Treasury yield curve or the swap rate curve. Studies show that there is a closer correlation between swap rates and mortgage rates than Treasury rates and mortgage rates.
Other factors that need to be modeled include:
- Loan size, keeping in mind the differences that would exist between a new pool’s loan size and a seasoned pool’s loan size as the former will exhibit greater refinancing efficiency.
- The points effect is usually modeled by making adjustments to the mortgage pool’s refinancing response and rate of seasoning. A high-point borrower has a steeper seasoning ramp and a quicker refinancing response as compare to a low or no-point borrower.
- Lower prepayment rate curves for mortgages with rate premiums where the levels of the rate premiums are calculated as the difference between the pool’s WAC and the conforming rate. The impact of credit quality diminishes with time as the house prices or personal income improves. This is usually incorporated into the model by grading the lower prepayment rates to the baseline case after a certain specified duration (between 2 to 5 years) since origin.
- The threshold effect is usually modeled using a look back variable which accounts for the absolute level of rates as well as the amount of time since such similar refinancing opportunities occurred in the past.
- The burnout effect is usually modeled using assumed distributions of fast and slow prepayments buckets or a historical cumulative refinancing incentive, etc.
The yield curve slope term is usually modeled by calculating the slopes between the short term and long term rates. An increased spread would indicate a steepening of the curve which would make refinancing into a hybrid more attractive.
(Foot Note: Care must be taken in identifying the rate premium borrowers because they could just as well be low point or no point borrowers. The prepayment behaviors of these two groups are very different. Whereas rate premium borrowers will not refinance when benchmark rates fall due to their credit quality acting as a deterrent to obtaining a lower rate, low point or no point borrowers who have higher contract rates will avail the first opportunity to refinance when rates fall.)