Rising rates will dampen what had been a growing cash-out refinance market even as equity available to homeowners continues to increase.
Homeowners pulled $105.2 billion in equity from their homes via cash-out refis during 2016, the most since 2009 and an increase of almost 41% from $74.6 billion one year prior, according to Black Knight Financial Services.
During the fourth quarter alone $31 billion of home equity, also the most in eight years, was taken out from properties via cash-out refis.
Mortgage loan prepayment speeds, a proxy for refi activity, have declined by 40% since the start of the year because of rising interest rates.
"The last time interest rates rose as much as they have over the past few months, we saw cash-out refinances decline by 50%, but rate-term refinances decline by 75%. Based on past behavior, we may see a decline in first-lien cash-out refinance volume, but it's still likely that cash-out refinances — and purchase loans — will drive the lion's share of prepayment activity over the coming year in any case," said Black Knight Data & Analytics Executive Vice President Ben Graboske in a press release.
During 2016, an additional $568 billion of home equity became available to property owners as values continued to increase. December marked 56 consecutive months of annual home price appreciation, Graboske said.
There are now 39.5 million homeowners whose combined loan-to-value ratio is under 80%, which would normally make them a candidate to do a cash-out refi. Nearly eight-in-10 of these homeowners have a credit score over 720. But since nearly 70% of these borrowers have an interest rate below the market, the incentive has shifted for them to pull cash out via a home equity line of credit, Graboske said.
Servicers must adjust their prepayment models to look at the borrower's incentive to refinance not just from a rate and term perspective but an equity perspective as well. "Additionally prepayment models will need a stronger focus on housing turnover as purchase transactions become a larger fraction of total prepayments," he continued.
The market share of cash-out refis is likely to rise. The last time interest rates rose, in 2013-14, rate and term refinance activity fell by over 50%. Cash-out loans made up 44% of refis in the fourth quarter of 2016 and if interest rates continue to rise, this should go over the 50% mark at some point in 2017.