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Refinancing risk is the degree of risk that the desired outcome of a particular financial transaction will not come to pass. For investors who acquire mortgage-backed securities, the risk is that the mortgages which support the securities will be paid off early, resulting in a lower amount of interest income. A borrower also experiences some degree of refinancing risk in terms of the ability to refinance the loan at a more competitive rate at some point in the future. In both examples, refinancing risk results in an inability to achieve the returns desired when the transaction was first implemented.
In the case of mortgage-backed securities, investors project the rate of return based on the interest rates that apply to those mortgages associated with the securities. While there is some allowance for shifts in loans that carry floating or adjustable interest rates, the expectation is that most of the mortgages will be paid off according to terms, and not retired early. When the mortgage holders are able to refinance the mortgages at lower rates, this decreases the actual return that investors receive. Savvy investors understand this type of refinancing risk, and will often consider how often this type of event has occurred with the security in the past before choosing to purchase the investment.
For individuals who obtain mortgages during a period when their credit is not sufficient to obtain the lowest interest rates possible, the hope is that the loan can be refinanced once those credit ratings are improved. In this situation, the refinancing risk focuses on whether or not the debtor’s credit rating does increase enough to command a lower rate of interest. If the chances of improving the credit rating are slim, then the refinancing risk that the debtor assumes with that initial mortgage is relatively high. For those who have excellent prospects of enjoying a higher credit rating within the next few years, the risk is considered low.
As with most investment opportunities, assessing refinancing risk as it relates to deals involving mortgages requires careful scrutiny on the part of the investor. For those who are considering the purchase of a mortgage-backed security, investigating the nature of the mortgages that support the investment, including the potential for early payoff, is vital to deciding if the level of risk is acceptable. For homeowners, being realistic about the chances for repairing damaged credit ratings is essential to minimizing the risk of not being able to refinance an existing mortgage at a later date, and obtain a better rate of interest.
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