National home prices have grown by about 15% over the past year, giving homeowners greater equity and financial security.
At the same time, rising prices have helped drive an increase in cash-out refinancing, where homeowners refinance to a lower mortgage interest rate while also taking money out by tapping into their increased home equity. In fact, according to Fannie Mae and Freddie Mac data, in 2020 approximately $185 billion of equity was extracted through cash-out refinances – the most since 2007, right before the Great Financial Crisis.
In many cases, a cash-out refinance makes sense, allowing a family to cover a medical emergency or a longer-term investment such as college tuition or a home renovation. But cash-out refinances can also carry risks that every homeowner – and every lender – should consider, especially during times of rapid home price increases such as now.
The risks of cash-out refinances
The first risk is simple. Home prices go up, and they go down. We’ve seen several cycles over the past few decades where home prices in many major markets dropped significantly. If a home’s value falls below the loan’s value, the borrower’s equity evaporates.
The second risk is using a home’s equity for quick cash instead of a cushion or a tool for building wealth. In a worst-case scenario, a homeowner might decide to use the family home as an ATM machine, taking out large amounts of money and making a risky assumption that home prices will keep going up indefinitely.
Between 2005 and 2007 in the run-up to the Great Financial Crisis, millions of borrowers extracted equity from their homes, fueled by skyrocketing prices, lax lending standards and speculative investors. Irresponsible lenders profited, but borrowers had to live with the fallout. The result was a tragic spiral of underwater mortgages, foreclosures and bankruptcies for families, and instability and weakness for the broader economy that took years to recover from. The financial health of some borrowers caught in that spiral has never recovered.
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Today, thanks to more responsible lending standards, many of the factors that led to the 2008 crisis are not present. The financial industry has learned many lessons from that time. Fannie Mae, for example, now requires that cash-out refinance loans be no greater than 80% of the home’s value. We also require at least six months of verified reserves for homeowners whose monthly debt payments are 45% or more of their monthly incomes. These standards help protect consumers and the housing finance system against risks such as falling home prices or economic shocks.
In fact, the overall picture of today’s cash-out refinance market is one calling for caution, but not alarm. According to Fannie Mae and Freddie Mac, only 36% of 2020 refinances resulted in a new mortgage balance that was at least 5% greater than the previous balance. Compare this with 78% of refinances from 2005 to 2008.
Before pushing refinance envelope
As home prices continue to rise, however, the temptation to push the envelope will likely grow for both lenders and homeowners. Homeowners considering a cash-out refinance need to keep a few key facts in mind:
►A mortgage is secured by your home. Unlike credit cards and many other loans, missing the monthly payments on your cash-out refinance loan could cost you your home.
►Refinancing is not free. Typically, closing costs run from 2% to 5% of the loan amount, skimming off some of the homeowners’ equity. In addition, while Fannie Mae and Freddie Mac won’t back a cash-out refinance loan with less than 20% equity, if a homeowner and lender choose to go that route, the homeowner should expect an annual mortgage insurance premium of 0.40% to 2.50% of the loan balance.
►Home prices can fall. No one knows for certain where home prices are headed. Anyone who says otherwise may not have your best interest at heart. Fannie Mae economists believe that home prices will continue to grow through the end of 2022. But that’s just our projection, and if you enter into a cash-out refinancing assuming it’s a certainty, you could be putting your home at risk.
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►Houses require upkeep. Roofs need to be repaired. Aging appliances need to be replaced. Maintenance costs can be expensive. By preserving home equity, families have a resource they can tap to make needed investments in their homes to maintain and enhance their property.
►There are other refinance options. A non-cash-out refinancing that lowers your interest rate can lower your monthly house payment, taking pressure off your budget. A refinancing that shortens your term can help you build equity faster.
These facts underscore one overriding truth: Homeownership can be one of the most effective ways of building wealth. However, entering into a long-term mortgage and building equity requires care and diligence. But the payoff in the years to come can be tremendous, helping families weather financial shocks and save for things like retirement and even passing wealth on to children or grandchildren. Pulling cash out of a home puts those long-term benefits at risk, so weigh the costs, benefits and risks carefully.
Sheila C. Bair is the chairwoman of Fannie Mae’s Board of Directors and former chairwoman of the Federal Deposit Insurance Corporation.
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This article originally appeared on USA TODAY: Home prices are rising but think hard before cashing out your equity