Home is Where the Equity Is: Liquidity Constraints, Refinancing and Consumption

This paper documents the extent to which homeowners use housing equity to smooth their marginal utility of consumption over time. Unlike drawing down other forms of saving, accessing accumulated home equity can be quite costly. As a result, households accumulating home equity could be liquidity constrained in the sense that they would like to access this equity to fund consumption but are unwilling to pay the costs to do so. Theoretically and empirically, a key distinction can be drawn between those refinancing their home mortgage to improve their wealth position from those who had a consumption smoothing motivation to refinance. Incorporating characteristics of a mortgage into a traditional permanent income model with exogenous liquidity constraints, one can understand household refinancing behavior in a world where mortgage interest rates are historically high and rising up to now, an empirical puzzle. This model predicts a large consumption stimulus as mortgage rates are reduced allowing liquidity constrained households to more easily access their accumulated home equity. Using data from the Panel Study of Income Dynamics, households that experienced a negative income shock and who had limited liquid assets to draw upon are shown to have been 19 percent more likely to refinance in the early 1990s. On average, liquidity constrained households converted over 60 percent of the equity they removed while refinancing into current consumption as mortgage rates plummeted between 1991 and 1994. In contrast, no such behavior was found in non-liquidity constrained refinancers. There was a corresponding stimulus of at least $18 billion from the refinancing activity of liquidity constrained households during the 1991-1994 period when mortgage interest rates were falling. JEL Classifications: E2, E4, G2.