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Home Mortgage

ABA DataBank: No early payoff

Mortgage prepayments remain unlikely to rise amid higher rates.

January 10, 2025
Reading Time: 3 mins read
New home sales fall in March

By Dan Brown and Jeff Huther
ABA DataBank

Now that the Fed is cutting short-term interest rates, there is once again the question of whether we may be on the verge of another prepayment boom. The basic answer is that this seems unlikely, given that many homeowners today are locked into very low mortgage rates. However, there are some aspects of the current environment that could lead to somewhat higher prepayment speeds.

Outstanding mortgage rates are significantly lower than current rates

Any reduction in mortgage rates large enough to make refinancings attractive would be unusual – mortgage rates would have to fall around 300 basis points to make refinancing financially attractive for most mortgages. The bars in Figure 1 show that almost 60 percent of mortgages in 2024 have interest rates of 4 percent or less while the horizontal line shows that the 30-year fixed mortgage rate is currently almost 7 percent.

Figure 1: Most mortgages have very low rates

Source: Federal Housing Finance Agency

The financial drivers of refinancings

While large scale refinancings are unlikely, prepayments could rise modestly in the current interest rate environment. The spread between mortgage rates and underlying Treasury interest rates can be thought of as a combination of multiple costs—servicing, credit risk, prepayment risk—that creates interest rate losses for lenders. Servicing costs are stable and credit risk is borne by government-sponsored enterprises for mortgages converted into securities (roughly half the total), so the spread between mortgage rates and Treasury securities varies mostly with changes in prepayment risk.

Mortgage investors face the risk that prepayments increase thereby reducing the length of time that they receive interest payments. To hedge that risk, investors buy interest rate options, particularly swaptions. Figure 2 shows a proxy for interest rate risk hedging costs (the price of a 1 year x 10 year swaption) and the spread between the 30-year mortgage rate and the 5-year U.S. Treasury rate. The two series are closely correlated — mortgage rate spreads rise when interest rate uncertainty rises (mortgage investors buy swaptions when they become more concerned that prepayments will reduce the value of their holdings). The current relatively high prices on swaptions implies a high level of interest rate uncertainty and suggests that there is room for spreads to narrow.

Figure 2: Mortgage rate spreads and interest rate uncertainty are closely related

Sources: Bloomberg for swaption data. U.S. Treasury and Freddie Mac through FRED for spread data.

One puzzle is why current prepayment rates are so much lower than the last time refinancing rates were financially unattractive (see Figure 3). Back in the 2010s, homeowners were able to withdraw equity from their homes through refinancings at low rates. Today, rates are significantly higher than the typical outstanding mortgage, leaving homeowners unable to withdraw equity through refinancing without making significantly higher mortgage payments. Therefore, the rate of refinancings in Figure 3 may understate the refinancing activity that could occur if rates fall one or two percentage points. Prepayment activity could also increase if the current lack of activity is due to a sizable cohort of “holdouts” who are hoping interest rates will fall below current levels before they move or withdraw equity. Even if interest rates do not decline much, some borrowers may conclude that the benefits of prepayment outweigh the relatively high borrowing costs.

Figure 3: Rate of refinancings are low, even by low standards

Source: Fannie Mae

Conclusion

As our analysis illustrates, the large cohort of outstanding mortgages that are currently well below the market rate means that a refinancing boom is unlikely. However, modest increases in prepayments should not be ruled out: Spreads may fall, making prepayments less costly, and some borrowers may ultimately not be deterred by relatively high interest rates.

Dan Brown is a senior director and economist at ABA. Jeff Huther is VP for banking and economic policy research at ABA. For additional research and analysis from the ABA’s Office of the Chief Economist, please see the OCE website.

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