Why Are Mortgage Refinance Rates Higher Than Home Purchase Rates?

Like scores of homeowners, when mortgage refinance rates began to fall in 2020, we refinanced our mortgage. We were excited to snag a 3.25% APR. However, if we had originated a new loan rather than refinancing our existing mortgage, our APR would have been 2.90%. Of all the mortgage lenders I checked today, only one offered the same rate to borrowers whether they were buying a new home or refinancing. I looked around and realized that most lenders offer higher rates to customers who refinance than to those taking out a new mortgage and wondered why. Here's what I learned.

New fee

Federally-backed home mortgage companies Fannie Mae and Freddie Mac are expected to suffer an estimated $6 billion in losses due to COVID-19. To offset those losses, a new 0.5% fee -- called the adverse market fee -- was applied to conventional loan mortgage refinancing beginning Dec. 1, 2020. Not everyone is subject to the higher refinance rate, however. Here's who's exempt:

• Borrowers whose principal balance is less than $125,000.
• Borrowers whose mortgage was not sold to Fannie Mae or Freddie Mac. For example, those refinancing VA and FHA loans won't pay the extra fee, nor will those whose mortgage lender kept the mortgage in house.

Demand

Once interest rates began to fall, some lenders experienced a jump in original loan applications of 400%. Just as they were swamped with new loan applications, lenders were inundated with current customers wanting to refinance their mortgages. The demand quickly became overwhelming for lenders to keep up with.

At the same time, most borrowers get a lower interest rate when they refinance, meaning the lender earns less money over the life of the loan. Because mortgage lenders are in the business to make money, many raised refinance rates a bit to maximize profits where they could.

Lenders have been so flooded with requests for new mortgages and refinancing that many decided to focus their attention on where the most profit is found -- originating new loans. For some, that meant reducing the number of loans they're willing to refinance. Some have also tightened loan qualifications.

Right now, homeowners are anxious to harness a new, lower APR through refinancing. And they seem to be willing to pay more than the amount new home buyers are paying for their mortgage loans.

Relative risk

To understand the risks involved, it helps to know about the three types of mortgage loans.

New mortgage origination: Whether the loan is for a first-time buyer or a veteran buyer, the purpose of these mortgages is to fund a home. New mortgage origination is the bread and butter of any mortgage lender, so this type has the lowest APR.

Rate-and-term refinance: Homeowners who refinance their principal balance without requesting cash out from the equity are known as rate-and-term borrowers. That's because all they want is to lower their interest rate and reset the term of their loan. Take a borrower who got a 30-year mortgage loan five years ago and now owes a balance of $275,000. If all that borrower wants to do is refinance the loan at a lower mortgage interest rate and reset the terms for another 30 years, the default risk is not likely to change by much. In fact, now that the mortgage payment has decreased, the risk may also be lower.

However, if the same borrower opts for a 15- or 20-year mortgage, the monthly payment may increase, even if the mortgage rate goes down. That borrower could be at higher risk of default. That's why rate-and-term loans are typically offered at a higher APR than loans offered to new home buyers.

Cash-out refinance: When a borrower requests a cash-out refinance, that means they want to change the loan rate and loan term of their mortgage while also taking money from the equity in their home. For example, a borrower may owe $200,000 on their mortgage but believe the house is worth more. The lender will require them to have a professional home appraisal to determine how much the property is worth. Say the borrower cashed out $25,000. When the mortgage is refinanced, it is for $225,000 plus any closing costs rolled into the loan. Not only does their loan-to-value ratio go up, but their debt-to-income ratio also rises. These borrowers are typically offered a higher APR than other borrowers because their default risk is greater.

Your rate may vary

Like all types of loans, the specific interest rate you're offered depends in large part on these three factors:

1. Your credit score: The higher your credit score, the more favorable your rate and terms.
2. Equity in your home: The more equity you have in your home (by putting more money down or cashing out less), the lower your rate.
3. Property type: Say you're refinancing a beach cottage, a second home you escape to whenever possible. The APR on that cottage is likely to be higher than it would be on your primary mortgage because lenders believe you are more likely to default on a second home than on your primary residence.

No matter what type of loan you apply for, make sure your credit is in good shape. If your credit is poor and you can wait to refinance, it pays to take steps to raise your score before applying.

Still have questions?

Here are some other questions we've answered:

• The Truth About Refinancing Your Mortgage
• Is Refinancing Worth It? Here's How to Find Out
• How to Refinance With Your Current Lender