Investors need to understand the risks associated with various investment products before they decide where to put their money and what returns to expect. A great deal of investment risk comes from changes in the price of securities. However, in other cases, changes in interest can derail an investment strategy. This is the case with both refinancing risk and the more general reinvestment risk.
Types of Refinancing Risk
There are two distinct types of refinancing risk. Refinancing risk refers to the risk that homeowners will, or will not, be able to refinance their mortgage loans. For homeowners, refinancing risk exists when there is a chance that it will be impossible to take advantage of better financing options in the future due to rising interest rates.
However, mortgage holders face an opposite risk, also known as refinancing risk. For a bank that issues a mortgage loan, or an investor who purchases a mortgage-backed security, the risk is that a homeowner will be able to refinance, paying off the loan early and not paying future interest that the lender or borrower was counting on for income.
Reinvestment risk is a more broad category of investment risk that includes refinancing risk. It refers to any scenario in which investors are subject to seeing their investments prepaid or cancelled. The risk comes from the fact that there may not be investments with the same growth potential or benefits available when existing investments terminate, which is out of the investor's control. Refinancing risk for mortgages is a reinvestment risk for lenders and mortgage-backed securities holders. Bonds also represent reinvestment risk, since early payment means lost interest.
Interest rates play a key role in both refinancing risk and reinvestment risk. In the case of refinancing risk for mortgages, falling interest rates give homeowners access to more affordable loans, which will drive them to refinance in larger numbers. For bonds, falling interest rates drive bond prices higher. However, they also eliminate high interest options for bond holders who will need to reinvest the money they receive when bonds are paid off, whether early or on schedule.
Investors can take steps to hedge against refinancing risk and reinvestment risk. In the case of mortgage-backed securities, investors estimate how many mortgages will terminate due to prepayment. As long as enough homeowners pay interest, the investment will still make a profit. Mortgage lenders also insert prepayment penalties into some mortgages to recover lost interest payments when borrowers prepay their loans by refinancing. Investors can reduce reinvestment risk by diversifying their investments and ensuring that some have fixed terms and fixed interest rates.