Why Does Mortgage Refinancing Cost More?

March 24, 2003 "Why are mortgage interest rates higher when the borrower is refinancing than when the borrower is purchasing a home?" If the borrower, the property and the loan are the same, one would think that a loan used to purchase a home would be priced the same as a refinance. Historically, this was in fact the case, but no more. Because of the prolonged refinance boom, refinancing loans are now priced higher than purchase loans. The boom has stretched to the limit the capacity of lenders to process loans. Reluctant to add more employees when the boom could fizzle out at any time, lenders have preferred to lengthen the processing period and let borrowers queue up for longer periods. But purchasers often have closing dates they must meet, and lenders strive to give them priority over refinancers. Pricing refinance a little higher is one way to do this because it cuts the number of refinancers in the queue. Another factor has been at work as well. It costs lenders more to lock the interest rate on refinance loans than on purchase loans. In the past, this was never important enough to cause a difference in pricing, but that has also changed during the recent refinance boom. When lenders lock, they assure the applicant that the rate will hold if market rates increase after the lock. Lenders lose if market rates are higher when they close, and they gain if market rates are lower. If loan applicants who lock always went to closing, over time, lenders would gain as much from rate declines as they lost from rate increases. But in practice borrowers do not always close, and the fall-out as it is called is larger when rates are falling. Some applicants are "lock-jumpers". They lock, and if rates subsequently decline, they find another loan provider and lock again at a lower rate. Locking thus imposes a net cost on lenders. This cost is larger on refinancings than on purchases because lock-jumping is more common among refinancers. Borrowers who are refinancing usually are flexible on when they close. Most purchasers, in contrast, must close on a specific date and don�t have time to restart the process with another lender. The prolonged refinance boom has increased the number of refinancing lock-jumpers. An unusually large number of borrowers have refinanced multiple times within just a few years, learning the ropes in the process. One thing they learn is how to lock-jump. This has widened the difference in lock cost to lenders between refinancings and purchase loans. Lenders and brokers are partly to blame for this because they only rarely put applicants on notice that they are committed by a lock. They fear that such a warning in itself could send the applicant running to another loan provider. But the result is to raise the cost to all those who refinance. Copyright Jack Guttentag 2003

Jack Guttentag is Professor of Finance Emeritus at the Wharton School of the University of Pennsylvania. Visit the Mortgage Professor's web site for more answers to commonly asked questions.

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