During periods of declining interest rates, many homeowners can refinance their mortgage and enjoy the benefits of a lower rate on their new loan. For borrowers who have accumulated enough equity in their home, refinancing might allow them to go one step further: In addition to reducing their interest rate, they may consider converting their equity into cash. By pursuing a type of mortgage refinancing known as “cash-out” refinancing, they not only receive a new mortgage with a lower interest rate (and perhaps a new timetable for payments); they also extract their equity in the form of cash. By “tapping their equity” in this way, these borrowers generate a lump sum of discretionary money they can use however they see fit. Borrowers determined to reduce their overall interest expense could, for instance, use the money to pay down higher-interest debt.

The financial benefits of using relatively low-interest debt (in this case, a refinanced mortgage) to retire higher-interest loans may seem straightforward. But do borrowers take advantage of this opportunity? They often do not, according to economists Mallick Hossain and Igor Livshits of the Philadelphia Fed and Collin Wardius, a doctoral student in economics at the University of California San Diego. They report this surprising finding in their paper, “Not Cashing In on Cashing Out: An Analysis of Low Cash-Out Refinance Rates.”

To gather evidence of homeowners’ indifference toward the rebalancing of debt, the authors study the behavior of homeowners who 1) have decided to refinance their mortgages, and 2) have outstanding balances on student loans. These borrowers, the authors contend, are particularly good candidates for rebalancing their debt obligations in favor of lower-rate loans: By using money from home-equity cash outs to pay down student loans, they would likely reduce their total interest expenses. (Indeed, over the last few decades, student loan rates were consistently higher than mortgage rates, sometimes dramatically so.)

To assemble a database of people who refinanced their mortgages while carrying a balance on their student loans, the authors sorted through millions of mortgage records and credit records, identifying cases in which the borrower appeared in both sets of records. As a result of this matching process, the authors arrived at a sample of nearly 770,000 refinanced mortgages, 42 percent of which include a cash-out component. They scrubbed the loan data to ensure that the details of each mortgage are represented as accurately as possible. (These details include demographic information about each borrower, as well as the size of the loan in relation to the market value of the home being mortgaged — what bankers refer to as the loan-to-value ratio.)

In a key component of their approach, Hossain, Livshits, and Wardius divide the refinancing decision into two stages. In the first stage, borrowers make the initial decision to refinance; in the second stage, borrowers decide whether to take out equity as part of the refinancing. In this way, the study focuses tightly on borrowers who have already decided to go through the mortgage refinancing process. (In other words, they’ve already made their first-stage decision.) By focusing exclusively on borrowers who are in the second stage, the authors “obviate the need to assess the discouraging [effects] … that may prevent borrowers who could benefit from refinancing from choosing to do so,” thereby putting a spotlight on borrowers who are left with one decision: whether to cash out equity in their homes.

The authors then burrow deeper into the tensions that might inhibit decision-making, looking at borrowers who have been incentivized to cash out their homes’ equity and use the proceeds to retire their student loans. These borrowers could have taken advantage of a 2016 special refinancing program introduced by Fannie Mae (initially in collaboration with SoFi, a private company that offers personal finance products). This program let homeowners use their equity to pay down student debt without incurring the fees that are typically charged for cashing out. By eliminating the fees, did the program increase the likelihood that borrowers would cash out? Yes, and no. On one hand, the authors find that, after the program’s launch, borrowers whose refinanced mortgages were securitized with Fannie Mae became significantly more likely to cash out compared to those whose mortgages went elsewhere. On the other hand, within the Fannie Mae sample, “the cash-out propensity for borrowers with student loans [did] not significantly change relative to borrowers without student loans,” even though the program did not apply to the latter. This striking and surprising finding suggests that the “nudge” aspect of the reform may have been more important than the monetary incentive itself.

Just how entrenched is this propensity for homeowners to forego a chance to improve their finances? Prior research has shown that borrowers have a variety of reasons for not cashing out to lower their interest payments. Borrowers may, for instance, be flustered by unclear information that fails to convey the benefits of cash-out refinancing. Borrowers may also be under the spell of inertia, or the tendency not to change their circumstances. Or they may be dissuaded by the previously noted fees that accompany a typical refinancing. These types of frictions are substantial. But even after these frictions have been removed, the researchers find that “many borrowers still do not convert high-interest debt into low-interest debt.”

As the authors note, borrowers may have practical reasons for holding on to their student loans. Some student loan programs, for instance, have a forgiveness clause, particularly for borrowers with incomes below a certain threshold. However, these programs apply to a relatively small number of borrowers, so, the authors argue, they are unlikely to account for why so many homeowners hesitate to cash out equity from their homes.

In showing that borrowers frequently forego cash-out refinancing — even when they could use the money to pay down higher-rate debt — Hossain, Livshits, and Wardius highlight homeowners’ extraordinary tendency to overlook strategies for lowering their overall interest payments. As their analysis shows, even when borrowers decide to lower the interest rate on their mortgage, “they do not extend that decision to the rest of their portfolio.” This means that a large portion of borrowers — amounting to millions of homeowners — are missing out on a chance to realize a meaningful economic gain. Whether it’s because of inertia, a lack of awareness, or trepidation about fees, these borrowers are paying more interest than they need to, raising an important question for future research: Would they benefit from a nudge toward rebalancing their debt obligations?

  1. The views expressed here are solely those of the authors and do not necessarily reflect the views of the Federal Reserve Bank of Philadelphia or the Federal Reserve System.