What is 'Refinancing Risk'
Refinancing risk refers to the possibility of an individual or company being unable to replace an existing loan with a new one at a critical time. One's degree of refinancing risk is strongly tied to the credit rating of the borrower, but external factors like interest rates and the overall condition of the credit market also play a large role.
BREAKING DOWN 'Refinancing Risk'
Refinancing risk is most pronounced in industries that depend on cyclical credit for their operations. Agriculture and inventory-based businesses, for example, can lose an entire year of operations if financing is unavailable at the terms they need to make a profit. Most businesses seek to limit their refinancing risks by working closely with lenders and investors to make certain they understand the needs of the business and emphasize a track record of servicing debt reliably.
Refinancing Risk in Personal Mortgages
Refinancing risk has an additional nuance when it comes to consumer adjustable-rate mortgages (ARM). Typically, refinancing risk is associated with short-term mortgage products such as hybrid ARMs and payment option ARMs. Borrowers often take on unforeseen risks when they assume that they will be able to refinance out of an existing mortgage at some future date — usually before a payment or interest rate reset date — to avoid an increase in their monthly payments. Interest rates might rise substantially before that date, or home price depreciation could lead to a loss of equity, which might make it hard to refinance as planned. This, of course, is essentially what happened in the subprime meltdown in 2007–08 when previously ignored refinancing risks came to fruition.
Refinancing Risk in Mortgage-Backed Securities
Refinancing risk is sometimes used to refer to an early unscheduled repayment of principal on mortgage-backed securities (MBS). These unscheduled payments occur when the underlying mortgages are refinanced by borrowers. This type of refinancing risk is more properly called prepayment risk, but terms get swapped about in the real world all the time. All MBS buyers assume some level of refinancing risk in their initial yield calculations, but an increase in the level of refinancing, which usually occurs as a result of falling interest rates, means that MBSs mature faster and will have to be reinvested at lower rates.
The prepayment estimates used to price mortgage-backed securities are based on market conventions known as prepayment speed assumptions (PSA) or speeds. There are two primary measures of mortgage prepayment speeds: the conditional prepayment rate and the Public Securities Association standard prepayment model. If the reported prepayment speed of the MBS is higher than planned, the refinancing risk for that MBS will go up. In a low-interest environment, refinancing will continue to rise and then suddenly cease as burnout sets in.