By Karen Dynan
In last week’s State of the Union address, President Obama urged Congress to pass legislation that would help more homeowners refinance. Much of the policy focus in this area has been on proposals that would modify the government’s Home Affordable Refinance Program, which helps borrowers with loans insured by Fannie Mae or Freddie Mac. However, other proposals would go further, such as one that is reportedly being developed to facilitate the refinancing of mortgage loans that are not backed by the government.
Finding ways to encourage refinancing is good policy. The Federal Reserve has done its part: Its asset purchase programs have helped to lower long-term interest rates to historically low levels. The interest rate on new 30-year fixed-rate mortgages is now around 3.5 percent, down from more than 6 percent prior to the financial crisis. Yet, many homeowners appear to have been blocked from refinancing into lower-rate mortgages. Indeed, data from the Commerce Department suggest that the average home mortgage has an interest rate of around 5 percent right now—much higher than the rate available on new loans.
One reason to promote refinancing is that the families that would be helped would tend to be among those less-advantaged and harder hit by the economic slump. Many of the proposals target “under water” homeowners (those with mortgages that are larger than the value of their homes) that are still current on their loans, because these people have had particular difficulty refinancing their mortgages. Based on the 2010 Survey of Consumer Finances, I calculate that median financial assets and median liquid financial assets in this group were only about half as high as the medians for all homeowners. A greater share had experienced job loss over the preceding year (22 percent versus 15 percent), and the median ratio of required debt service payments to before-tax income for this group, at 0.31, was close to double that for the broader homeowner group.
A second reason to support such proposals is that more refinancing would be good for the economic recovery. A family with a $150,000 30-year mortgage with a fixed interest rate of 6 percent that refinances into a new loan with an interest rate of 4 percent will lower its mortgage payments by $180 a month or $2200 a year. The weak retail sales report we saw in the wake of the recent expiration of the payroll tax cut suggests that the spending of many families is very sensitive to the ups and downs in their discretionary monthly cash flow. Thus, we should expect that the interest savings from refinancing will translate into stronger consumer spending and, in turn, promote more hiring and a stronger economic recovery.
It is true that the individuals and institutions that provided the funding for mortgages would lose out if refinancing picks up because they would receive lower interest income. However, these investors lent money for mortgages knowing that borrowers had an option to refinance, and, so far, they have seen much smaller losses than would be the case if it were not unusually difficult for many borrowers to refinance. Moreover, the net effect on the economic recovery should still be positive, as the spending of this group is unlikely to be as sensitive to their losses as the spending of refinancing borrowers is to their gains.
A third reason that proposals to facilitate refinancing make good sense is that, if designed right, they need not impose significant costs on the government. An oft-heard worry is that the programs will expose the government to yet more risk in the housing area. But, for mortgages already insured by the government, lowering mortgage payment burdens would reduce the probability of default. For other mortgages, where proposals typically involve a government entity purchasing the loans before issuing new ones, the risks can be mitigated by limiting the program to homeowners that are in good standing with their mortgages and trying to set the prices paid for the old loans and the interest rates on the new loans to reflect any greater credit risk associated with these borrowers.
Refinancing proposals are not a magic bullet for the economy. Reports vary on how many mortgage borrowers will be helped, but even under generous assumptions—that 10 million borrowers with high spending propensities would achieve interest savings of a couple thousand dollars a year—the programs might raise GDP growth by only ¼ percentage point or so. But, with the enormous burden associated with the still-high rate of joblessness and most economists expecting only tepid economic growth over the coming year, it seems like we should be doing all we can.
Karen Dynan is vice president, co-director of the Economic Studies program, and the Robert S. Kerr Senior Fellow at the Brookings Institution where she focuses on macroeconomic and household finance issues.