What is a Refi Bubble
A refi bubble, where "refi" is short for "refinance," refers to a period during which borrowers refinance old debt obligations en masse, replacing them with new debt with different terms. The typical motivation for refinancing is to take advantage of lower interest rates. Refinancing and refi bubbles can also occur if assets, such as homes, rise substantially in price and borrowers want to access the equity in their homes by taking out new loans for higher amounts.
BREAKING DOWN Refi Bubble
Many types of loans can be refinanced, including business loans and personal loans, such as credit card debt, mortgages and personal loans, though refi bubbles are often seen in mortgage loans. Refi bubbles track the general trend of interest rates in an economy, which are affected by a multitude of factors. When interest rates are rising, refinancing is unattractive, as borrowers would be taking out new loans with higher interest rates than their original loan, which would cost them more.
As interest rates fall, however, refinancing becomes an attractive option for borrowers, and refi bubbles occur. This scenario played out in late 1998 and early 1999, as interest rates in the U.S. dropped and many mortgage borrowers refinanced, causing a refi bubble. However, as rates moved up in mid- to late 1999, refinancing dropped by over 80%. Rising valuations may also lead to refi bubbles, such as with the rapidly rising real estate market of 2006. Home prices at the time were rising by 10% to 20% in some regions, and borrowers were refinancing old loans based on cheaper valuations for new ones with a higher amount borrowed, giving them access to their equity.
Interest Rates and Refi Bubbles
The ongoing cost of borrowed funds is the interest rate charged by the lender and paid by the borrower. If interest rates, in general, have been declining in an economy, borrowers may find that current rates are much lower than they were at the time their loan was taken out. In this case, borrowers can lower the interest rate on their loan by working with a lender to refinance their debt. In a typical refinance, the borrower finds a lender offering better loan terms, usually a lower interest rate. The borrower then takes out a new loan with the lender that is used to pay off the old loan, and then repays the new loan according to its terms.
For example, assume Tom took out a hypothetical 30-year mortgage loan 10 years ago that charged an interest rate of 7.5%. The economy has since entered recession, and the central bank took steps to spur spending and economic growth, resulting in lower interest rates. The interest rate on a hypothetical 20-year mortgage is now 3.5%. Tom could refinance his loan, paying off what is left of his original mortgage with the new mortgage for the same amount at the lower 3.5% interest rate. There are fees and costs associated with refinancing, and borrowers should weigh the savings in interest costs against these fees and costs to ensure the refinance is sensible.