U.S. mortgage applications slid to a more than 3-1/2-year low last week amid a sharp drop in refinancing demand even as interest rates held steady, the Mortgage Bankers Association said on Wednesday.

The MBA said its seasonally adjusted index of mortgage applications for the week ended December 23 decreased 6.8 percent to 554.1 from the previous week's 594.6. Volume was at its lowest level since the week ended May 24, 2002, when the index hit 516.9.

The group's seasonally adjusted index of refinancing applications dropped 11.2 percent to 1,259.1, compared with 1,418.1 the previous week. Volume was at its lowest level since the week ended April 12, 2002, when the index touched 1,246.1.

A slowdown in refinancing, particularly the conversion of home equity into cash or "cash-out refis," could lead to less U.S. consumer spending in 2006, analysts said.

"Less refinancing activity should dampen consumer spending -- although that has not yet occurred," said Steven Wood, chief economist at Insight Economics, in a report.

Home equity extractions through cash-out refis are forecast to fall to $114 billion in 2006 from $204 billion this year, according to Freddie Mac, the second largest U.S. home funding company.

MBA's seasonally adjusted purchase mortgage index fell 4.5 percent to 432.9 from the previous week's 453.1, its lowest level since February. The index is considered a timely gauge of U.S. home sales.

An adjustment was included in the data to help account for reduced application activity prior to the holiday weekend, the MBA said.

Loan demand has waned as the rate difference between fixed and adjustable loans shrank by more than half a percentage point so far this year.

The rate spread between fixed and adjustable mortgages has narrowed with a flattening of the yield curve, a shrinking in the yield gap between short- and long-dated bonds.

Low adjustable-rate mortgages had made homes affordable even in the most expensive housing markets and will likely send home sales to another record in 2005.

"Although mortgage rates have declined over the past three weeks, mortgage applications volumes have continued to fall. This is partially due to the flat yield curve and partially due to tighter lending standards by financial institutions," said Insight Economics' Wood.

Long-dated bonds typically command yield premiums above shorter-dated issues to compensate for longer exposure to future inflation risk.

However, the recent wave of tame inflation data has kept longer U.S. yields steady while shorter yields have climbed on expectations that the Federal Reserve would raise short-term rates at least one more time in 2006.

On Wednesday, there was less than a 0.01 percentage point difference between the two-year and 10-year yields.

Borrowing costs on 30-year fixed-rate mortgages, excluding fees, averaged 6.21 percent, down 0.01 percentage point from the previous week's 6.22 percent but above its 2005 low of 5.47 percent in late June.

Rates on one-year adjustable-rate mortgages fell to 5.36 percent from 5.41 percent.