With interest rates declining to record lows during 2020, the U.S. mortgage market had the largest number of originations in 17 years and the second largest on record, according to CoreLogic data. This peak volume was driven by traditional rate-and-term-refinances as the data showed that more than half of all loans originated last year (as well as four in five refinances) were non-cash-out refis.
Fixed rates were at an all-time low at the beginning of 2021 and have moved higher since then. While forecasts vary, the consensus view among economists is that mortgage rates will rise between 25 to 75 basis points during the next 12 months. More expensive credit will likely reduce refinance volumes and alter the characteristics of borrowers who refinance. Mortgage lenders and originators should anticipate larger shares of refis that include cash out, longer terms and lower credit scores.
When mortgage rates reach new lows, rate-and-term refinances dominate the market as homeowners seek lower payments or shorter terms. When rates rise and are well above a recent low point, the mix of refis shift toward cash-out loan products. Mortgage rates rose by about 1.5 percentage points from 2012 to 2018. CoreLogic estimates that the cash-out share grew from 10% to 40% of refinances. Last year’s cash-out share, however, fell to 20% of refis. If mortgage rates rise in the coming year, expect the cash-out share to rise as well.
Borrowers who refinance when interest rates begin to rise also prefer to keep monthly payments low. This is a reason why the terms of refinance mortgages generally get longer as rates move higher. As an example, a borrower who has a 15-year loan and wants to obtain a cash-out refinance may opt for a 30-year term in order to keep the monthly payment as low as possible. During the rise in mortgage rates from 2012 through 2018, the share of borrowers with a 15-year loan who chose to refinance into a 30- year term loan increased from 12% to 50%. By 2020, this share had fallen back to 28%, but it is likely to rise once again when mortgage rates increase.
Borrowers with lower credit risk often dominate the applicant pool during a refinance boom. As interest rates rise, applicants with more complex underwriting requirements become more common. Since 2009, there have been five rising-rate cycles during which the average rate rose by at least half a percentage point. In each instance, CoreLogic determined that the average credit score of borrowers who refinanced declined. On average, credit scores dipped by 10 points for every 60 basis-point increase in mortgage rates.
For instance, mortgage rates rose by 150 basis points between a low point in 2012 and a peak in 2018, and the average credit score of a refinance borrower declined by about 25 points during this time span. Rates then fell by more than 2 percentage points until reaching a record low at the start of 2021 while the average credit score of a refinance borrower rose by slightly more than 30 points.
As mortgage rates gradually move higher in the coming year, expect these same trends to reemerge among borrowers who apply for a refinance loan. More of these clients will want to take cash out or obtain a longer term while more will have blemishes on their credit history. ●