Optimal mortgage refinancing: application of bond valuation tools to household risk management

Andrew J. Kalotay, Deane Yang and Frank J. Fabozzi

Applied Financial Economics Letters, 2008, vol. 4, issue 2, 141-149

Abstract: Despite the enormous volume of refinancing activity in conventional residential mortgages, reaching record levels during recent years of historically low interest rates, the solution to the problem of how to time refinancing decisions optimally has remained elusive. It is recognized that the decision should depend, among other factors, on the ‘call’ options of the outstanding and the new mortgage. Determining the value of these options is a challenge in the absence of an observable optionless mortgage yield curve. We solve this by calibrating a benchmark interest rate process to the value of the new mortgage and then apply the notion of refinancing efficiency to the timing decision. In particular, risk-averse decision makers can use refinancing efficiency to measure how close to optimal a refinancing is. We analyse the sensitivity of the decision to interest rate volatility and also show how to incorporate homeowner-specific considerations, namely borrowing horizon and income taxes. While calibration and refunding efficiency are well-known techniques in bond analysis, there is no evidence, hitherto, of their application to the mortgage-refinancing problem.

Date: 2008
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DOI: 10.1080/17446540701493729

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