What is Refinancing Risk?

"Refinancing risk" is a term that is associated with two different types of scenarios in the financial industry. The first scenario involves the risk that individual mortgages in mortgage-backed securities will refinance. The other meaning deals with the risk that is associated with a business or individual not being able to refinance their loan under terms that would be considered suitable.

Mortgage-Backed Securities

Mortgage backed securities are a type of investment that many individuals can get involved with in order to speculate in the real estate market. When a primary mortgage lender initiates a mortgage with an individual, they will often package it with other mortgages and sell them to investors. These packages are made up of hundreds of mortgages.

Owning a portfolio of mortgage-backed securities has what is called refinancing risk. When interest rates in the mortgage industry become very low, there is always the possibility that existing homeowners will want to refinance their mortgages. When borrowers can get out of their mortgage and into a lower interest rate, they will refinance When this happens, the mortgage-backed securities holders lose out on a lot of their returns. Once the home is refinanced, the mortgage-backed securities holder will not be able to continue receiving payments from the homeowners. This will reduce the amount of yield that is possible with this type of investment.

On the other end of the spectrum, mortgage-backed securities holders also have to be aware of what could happen if interest rates increase. If rates increase substantially, a mortgage payment can increase very high and cause a foreclosures to occur. If the mortgages are adjustable rate loans, many people will have mortgage payments that they can no longer afford to make. They will default on these loans and this will also ruin the investment of the mortgage-backed securities holders.

Unable to Refinance

"Refinancing risk" is a term that is also used to describe a situation in which an individual cannot refinance their existing mortgage. For example, many people take a balloon loans for business purposes or for their mortgage. When they take out a balloon loan, it is typically so that they can have a very low mortgage payment. They will only have to pay the interest that is accruing each month as their mortgage payment. They do this with the idea of refinancing into a traditional loan before the balloon payment comes due.

While this scenario is possible, sometimes people run into problems along the way. When they go to refinance the existing loan before the balloon payment comes due, they might be unable to get approved. If their credit has deteriorated during the loan term, they may be unable to qualify for a new mortgage. 

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