Optimal mortgage refinancing

Application of bond valuation tools to household risk management

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

Research output: Contribution to journalArticle

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.

Original languageEnglish (US)
Pages (from-to)141-149
Number of pages9
JournalApplied Financial Economics Letters
Volume4
Issue number2
DOIs
StatePublished - Mar 2008

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Bond valuation
Household
Risk management
Refinancing
Mortgages
Interest rates
Risk-averse
Interest rate volatility
Borrowing
Call option
Decision maker
Benchmark
Calibration
Income tax
Yield curve
Factors

ASJC Scopus subject areas

  • Economics and Econometrics
  • Finance

Cite this

Optimal mortgage refinancing : Application of bond valuation tools to household risk management. / Kalotay, Andrew J.; Yang, Deane; Fabozzi, Frank J.

In: Applied Financial Economics Letters, Vol. 4, No. 2, 03.2008, p. 141-149.

Research output: Contribution to journalArticle

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