Homeownership may be the American dream, but an increasing number of academics and policy makers say that as a wealth-building tool, it too often perpetuates inequality between people of different races, ethnicities, and economic classes. This dynamic is on stark display in homeowner refinancing patterns. Financially sophisticated households are quick to take advantage of better borrowing conditions, whereas less savvy households tend not to, whether because they’re unaware of such opportunities, unable or reticent to remortgage, or some combination of those factors.

The problem is amplified by the mortgage-origination process, according to a study by Duke’s David Berger, Northwestern’s Konstantin Milbradt, Fabrice Tourre of the Copenhagen Business School, and Chicago Booth’s Joseph Vavra. The researchers explain why this is, and why the problem can be so hard to solve.

Their work takes as its starting point a growing consensus that less-financially-savvy households refinance less often than those who have the know-how and wherewithal to access the most beneficial financial tools.

“People have argued, ‘This is a problem that’s generating inequality, and we should redesign the mortgage market to recognize it,’” Vavra says. But, he explains, many of the policy interventions that have been suggested so far don’t take into account the entire mortgage-market landscape, a flaw that may wind up being detrimental to all borrowers.

The researchers used loan-level, anonymized mortgage data from credit rating agency Equifax for the years 2005–17, sorting borrowers based on their attentiveness to changes in the marketplace and their opportunities to refinance. By comparing the existing interest rate on a loan with the prevailing market rate, they were able to gauge whether people missed out on opportunities to refinance when it would have been financially advantageous to do so. (Where possible, they controlled for complicating factors such as a homeowner’s low equity or low credit score.)

Attentiveness is one friction preventing a more efficient refinancing market. The costs associated with refinancing may also make it unattractive for some borrowers.

One popular reform proposal suggests that mortgages be designed to refinance automatically when certain thresholds are met. This might seem beneficial to borrowers for many reasons: Homeowners wouldn’t need to monitor mortgage markets and make a proactive decision about the right time to refinance, for one thing. Nor would they have to go through the process of comparing rates and putting in an application.

But the automatic-refinance approach, Vavra says, fails to take into account the likely response of lenders to the new market landscape. “If you’re changing around mortgage contracts substantially, it’s likely that lenders are going to change their behavior in response,” he says.

How automatic refinancing can make households worse off

Research finds that if all mortgages were to refinance automatically to help less financially savvy households, lenders could respond by raising rates. Higher rates would push more borrowers above a debt-to-income ratio of 43 percent, which is the limit to get a “qualified mortgage” that offers borrowers better terms. 

Lenders may proactively make the application process more stringent, raising rates or fees enough to price some borrowers out. Such responses may increase costs for all borrowers, the researchers write. Additionally, they may lock some out of the mortgage market altogether.

Higher interest rates resulting from automatic refinancing could force about 20 percent of borrowers to buy smaller, cheaper homes, according to the study. This would create an obstacle in the current housing market, which faces steep constraints on affordable homes.

The researchers also examined the effects of financial-literacy efforts, which might prompt some households to refinance when it makes sense to do so. If that happens for borrowers who would otherwise not have paid attention to changing financial conditions, it’s certainly better for them.

But other borrowers will slip through the cracks, the researchers point out. “Slow borrowers who do not become more attentive are unambiguously made worse off by these policies: if other borrowers become more attentive and refinance more rapidly, lenders will increase mortgage rates” in the broader market, they write. “This means that the borrowers who remain slow to refinance now pay higher rates at origination and receive no compensating benefit arising from faster refinancing.”

The same patterns could hold true for subscription-based consumer products and services such as cell phones or cable, the researchers write.

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