The Hidden Risk of Lower Interest Rates: Why Refinancing May Not Be as Simple as It Seems

As the possibility of lower interest rates looms on the horizon, many homeowners and buyers are excited about the idea of refinancing their loans and saving on their monthly payments. However, there’s a risk that comes with those lower rates that many people aren’t aware of. It’s not all smooth sailing when interest rates drop, and here’s why.

When interest rates fall, the floodgates of refinance opportunities open up. But contrary to popular belief, it’s not going to be the free-for-all savings frenzy everyone expects. Lenders, especially those that service mortgage loans, will face an overwhelming influx of applications. And to manage this influx, what you may not know is that these lenders will often raise interest rates—not lower them—to slow down the volume.

Yes, you read that right. Mortgage lenders, particularly servicers (those who handle your mortgage after it’s been issued), will increase rates to offset the surge in applications. Why? They simply can’t handle the processing volume all at once. Additionally, they’re dealing with the potential loss from all those existing mortgages they’ve issued at higher rates over the past six months to a year.

The COVID-19 Precedent: A Warning for the Future

Most recently, we saw this happen during the COVID-19 pandemic. While rates dropped to record lows, many lenders raised rates slightly to control the surge in applications. We’re not likely to see rates as low as they were during the pandemic, but even a modest dip will bring in more volume than many lenders can handle.

So, what happens when the volume spikes but the capacity to process loans remains limited? Lenders slow down the pipeline by nudging interest rates up. This might seem counterintuitive, but it’s a practical solution for lenders managing an unsustainable surge in demand.

Moreover, the situation is compounded by a significant problem for mortgage servicers—prepayment risk. This refers to the risk of losing revenue when borrowers pay off their loans early, typically through refinancing. Servicers rely on the revenue generated from holding loans over time, and when rates drop, the risk of prepayments increases. Every time a borrower refinances to a lower rate, the original loan gets paid off, and the servicer loses out on the expected revenue stream from that mortgage. The portfolio of loans held at higher rates suddenly becomes a financial burden.

Why Prepayment Risk Matters to Mortgage Servicers

Here’s the critical piece that many borrowers don’t realize: Mortgage companies that service loans today are sitting on a mountain of loans issued at rates of 6.5% or higher. As soon as rates drop to, say, 5.5%, these loans are at risk of being paid off early, and the servicer takes a hit. Multiply this by millions of mortgages, and you can see why mortgage servicers are in a tricky position.

The industry refers to this challenge as hedge risk. It’s the risk servicers face when they must cover the financial gap created by early payoffs. To mitigate this risk, mortgage companies may raise rates to slow down refinancing activity. This helps them manage their exposure to sudden losses and buy time against what’s known as the early payoff (EPO) timeline.

Normally, borrowers can refinance their loans after six months without triggering significant penalties or financial impacts for lenders. However, even after six months, mortgage servicers lose money because they’ve invested in the servicing value of those loans, expecting a long-term payoff. When loans are refinanced too soon, that value never materializes. In a market where millions of loans are refinanced, the combined financial loss can be staggering.

The Impact on Borrowers: Expect a Bump in Rates When the Market Opens

If you’re a homeowner considering refinancing when rates drop, you might think waiting for the absolute lowest rate is the smart play. But here’s the reality: Chasing after an additional 0.25% or 0.5% reduction in your rate could cost you more in the long run. Mortgage lenders and servicers are well aware of how to manage the flood of applications that come when rates fall, and they will likely preemptively raise rates to curb that volume.

This is where borrowers can get caught off guard. You might think, “I’ll wait until rates drop another fraction of a percentage point to save a little more on my monthly payment.” But the reality is, that lower rate may never come—or if it does, it could be short-lived as lenders adjust to protect their balance sheets.

Here’s a practical example: Let’s say you can refinance today and save $400 per month by locking in a new rate at 6%. If you hold out for a rate that’s 0.25% lower, hoping to save an additional $40 per month, you’re essentially delaying savings that are available to you right now. Over six months, you’d miss out on $2,400 in savings just to chase an extra $240 per year. It could take you five years to break even from waiting for that slight rate drop—and that’s if the market cooperates.

Why Refinancing Now Might Be Your Best Option

If you can refinance and save money now, do it. Waiting for rates to drop further in hopes of squeezing out a slightly better deal could cost you more than you save. The reality is, rates have to fall significantly—below 6%—to make waiting worthwhile. And given how mortgage lenders respond to increased volume by raising rates, there’s no guarantee that you’ll lock in the rate you’re hoping for.

It’s important to remember that refinancing isn’t a one-time option. If rates drop even further in the future, you can always refinance again. But by locking in a lower rate now, you’re putting real savings back into your pocket immediately, rather than gambling on the unpredictable swings of the market.

What Happens if Rates Drop Further?

While it’s possible that rates could dip into the mid to high 5% range, the financial landscape today is different from what it was during the pandemic. There’s no guarantee that rates will reach those same lows. And even if they do, mortgage lenders—especially those servicing loans—are likely to sandbag new loans to protect themselves from prepayment risk.

For borrowers, the takeaway is clear: Don’t wait for the perfect rate. If you can save money today by refinancing from 6.5% or higher to something in the mid-5% range, take the opportunity. The extra savings from waiting for a fractionally better rate simply doesn’t outweigh the real-world savings you can lock in right now.

Conclusion: The Balance of Risk and Opportunity

The possibility of lower interest rates brings both excitement and risk. While the prospect of refinancing to save on your mortgage payments is enticing, it’s essential to be realistic about what will happen when rates start to drop. Lenders will protect their interests by raising rates to slow down the flood of applications, and mortgage servicers will be especially cautious due to the risks associated with early payoffs.

If you have an opportunity to refinance now and save money, don’t let the pursuit of a slightly lower rate hold you back. The savings you can secure today are tangible, while future market conditions are unpredictable. And remember, you can always refinance again if rates drop further. But waiting too long could mean missing out on the significant savings available right now.

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