Prepayments jump 14% in small but important market segment

Many outstanding mortgages lack interest rate-related incentives to refinance but there nevertheless were notable increases in prepayments in February that occurred as other servicing risks subsided. 

"At a high level, delinquencies fell, foreclosures fell and prepayments rose," said Gunnar Blix, director of housing market research at ICE Mortgage Technology, summarizing some takeaways from the latest Mortgage Monitor analysis of monthly data during a client webinar.

Delinquencies will likely remain subdued this spring due to tax refunds, but prepayments could continue to tick upward as housing turnover increases during the spring homebuying season and a small but important segment of loans remains exposed to refinancing incentive.

Mortgage rates peaked at 7.79% in Freddie Mac's survey last year, and loans originated between that level and the 6.79% average recorded during the week ending March 28 have been potential prospects for refinancing, and they appear to have been responsive.

While a less influential driver of the rise in prepayments than housing turnover and curtailment, refinances rose a notable 14% to a 17-month high in February, said Andy Walden, vice president of enterprise research strategy at ICE.

Overall, prepayments rose just 6.3% to a high not seen since October.

"Prepayment activity was very low in October, but I think there are a couple of things that kind of catch your eye when you start looking at prepayments in the transition we've seen over the last couple months. One of them is that refinance activity bumped up," Walden said.

Speeds for the 2023 vintage in particular have risen 68% from 5.53% percent in November to 9.33%, Walden said.

"That will be the one to watch this year, not only from an origination perspective and an opportunity perspective, but certainly we'll see its needle move the most from a prepayment perspective," said Walden.

In contrast, older loans bearing significantly lower rates continue to serve as a strong deterrent to prepayments driven by housing turnover.

Around 40% of the market took out mortgages in 2020 and 2021 when rates were at record lows, Walden said. Those borrowers' monthly principal and interest would grow by 60% if they bought a house equivalent to their own located across the street, according to the ICE research.

The average cost for the current mortgage-market overall to make a similar move is 40%. It's a number likely to give homebuyers pause because the more typical rule of thumb in the housing market is that one should be able to get a move-up home once that kind of premium is paid.

In contrast, the average 2020 to 2021 vintage borrower would have to pay 132% more in P&I to afford a move-up home.

With the Fed on track to lower short-term interest rates this year with a possible reduction in mortgage costs as well, there is some hope that the lock-in effect could be reduced; but Walden warned that's unlikely to happen in short order.

Walden estimated that even if the current mortgage rate were to fall to 5% many borrowers would remain locked in given that many got loans in 2020-2021.

"It's going to take some time to loosen up the market, but certainly falling interest rates will start to shift the dynamic," he said.

A recent deceleration in the Personal Consumption Expenditures index that policymakers watch closely as an inflation indicator may have increased the chances of a short-term rate decline in the first half of this year.

At the time of this writing, Fed Fund Futures were showing a 60% probability of a 25 basis-point short-term rate cut in June, but such indicators have generally been overly optimistic, said Jack Macdowell, co-founder, managing member and chief investment officer at Palisades Group.

The degree to which mortgage rates fall could be limited, said Macdowell, whose company is an alternative asset manager specializing in residential credit. Company models suggest a 90 basis-point reduction at most in broader market benchmarks that skew higher than Freddie's.

"Based on current data, it is hard to envision more than one to two cuts in 2024 and hard to see mortgage rates drop below 6.25%, as measured by either Bankrate.com (7.25%) or the Mortgage Bankers Association 30-year effective rate (7.10%)," he said.

A drop of a percentage point from Bankrate's number "would likely release pent-up demand into an undersupplied housing market, resulting in unwanted housing inflation," he said.

"Mortgage rates would likely need to fall to the low-to-mid 5% range before borrowers become comfortable leaving behind their low-rate mortgages, thereby initiating the release of pent-up deferred sales and leading to much-needed supply-demand parity," Macdowell said.