Many American homeowners are re-embracing a once-popular method of generating cash: refinancing their home loans and getting cash out in the process.
Five years ago, in the continuing wake of the financial crisis, only 12 percent of homeowners were taking cash out when they refinanced.
That proportion has now risen to 49 percent — the highest level since the fourth quarter of 2008 — according to data from Freddie Mac, graphed here by The Wall Street Journal.
Homeowners typically refinance to take advantage of a lower interest rate or to get a loan with a shorter term (for example, replacing 30-year mortgage with a 15-year loan). But in a cash-out refi, the main goal is to tap into rising equity driven by increases in home prices. A homeowner comes away with a new loan larger than the one being replaced. The borrower pockets the difference between the old balance and the new loan (minus refinancing costs). The “new” money is used (typically) to fund a home renovation, pay off other debt, or to buy something.
If home prices reverse course and start falling, the cash-out borrower can quickly end up "underwater" (owing more on a property than it's worth).
From a story in today's WSJ:
To some housing-market observers, the fact that more homeowners are tapping their homes for cash represents a healthy confidence in the economy. It comes against a backdrop of continued gains in employment.
At the same time, the increasing use of cash-out refis causes some concern since, in the run-up to the financial crisis, borrowers used their homes like veritable ATMs.
Len Kiefer, Freddie Mac’s deputy chief economist, says this time has been different. Borrowers now are subject to stricter standards when they get a loan or refinance a mortgage. There is also less money at stake now than a decade ago.
Cash-out refis in the first quarter represented about $14 billion in net home equity compared with more than $80 billion in each of three straight quarters in 2006....
And despite the recent increase in users, the proportion of refinancers opting for cash is much lower than in pre-crisis days, when it peaked at nearly 90% in mid-2006.
It’s true that “this time has been different.” There are stricter standards now. But that doesn’t mean that this time it will be different for many of the borrowers now doing cash-out refis.
Taking on more debt always carries some degree of risk — a risk that may an especially bad idea for older homeowners. As The New York Times reported in November:
More than three-quarters of Americans over 65 [are] homeowners.... Those houses usually represent their greatest single asset.
But often there’s little equity left, even as prices have largely recovered, because so many older homeowners have borrowed against their homes.
As housing values rose more than 60 percent nationally between 2000 and 2006, [older] homeowners...(more than younger ones) refinanced and took out cash, or signed up for home equity loans or lines of credit.
I’ve witnessed the bad fruit of a cash-out refinancing. I know an 82-year-old widow who still has more than two decades(!) remaining on her home mortgage because of an unwise cash-out refi.
That’s not to say that all cash-out refinancings are bad. Sometimes a well-planned renovation paid for with a refi can help preserve the value of a home. But a cash-out refinancing shouldn’t be undertaken without careful thought about the cons as well as the pros.
Our SMI recommendation is to keep your monthly home-related expenses (i.e., principal, interest, taxes, and insurance) to an amount no greater than 25 percent of your monthly gross income — preferably no more than 20 percent. And plan to have your mortgage debt paid off no later than the time you retire.
Have you ever done a cash-out refinance? If so, why? Would you do it again? Tell us in the comments section.