Exercising Care and Caution with Cash-Out Financing
In 2020, the United States witnessed a real estate phenomenon. Interest rates dropped, home prices rose, and U.S. homeowners pulled out nearly $185 billion from their homes’ equity through cash-out refinancing, representing the highest amount of equity pulled out since 2007. However, analysts are now warning homeowners to be cautious when pursuing a cash-out refinance. Here’s why.
Why Cash-Out Financing Skyrocketed in 2020
Once the pandemic hit, the United States took the initiative to preserve the economy. In March 2020, the Federal Reserve announced interest rates had dropped to zero. This favorable rate catapulted a change in the housing market, driving both interested buyers and current homeowners to leverage low rates. However, as more buyers entered the market, sellers began to stall, indicating a desire to wait for the pandemic to end before considering a sale. The increase in buyers and decline in sellers resulted in low inventory, causing home prices to soar. In fact, according to a CoreLogic report released in May 2021, national home prices saw a 15.4 percent year-over-year increase. This was the highest increase in home values since 2005 and the fourth consecutive month of double-digit growth.
Today, many homeowners are still pursuing cash-out refinancing, but experts in the industry have been sharing their anxieties about this trend’s future.
Sheila C. Bair, chairwoman of Fannie Mae’s board of directors, shares the following: “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.” She continues, “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.”
Risks of Cash-Out Refinancing?
Cash-out refinancing may seem like a no-brainer given the economy. It is a simple way to access capital to complete whatever project you have in mind, whether it be a remodel of your home or paying off your existing credit card debt. However, before heading to the bank, homeowners should be aware of the following risks, according to the experts:
- Cash-out refinancing reduces an owner’s equity in the home, and this could have a long-term negative impact on the homeowner’s future plans.
Bair explains, “Homeownership can be one of the most effective ways of building wealth.” She continues, “However, entering into a long-term mortgage and building equity requires care and diligence. The payoff in the years to come can be tremendous, helping families weather financial shocks and save for things like retirement or even pass wealth on to children and grandchildren. Pulling cash out of a home puts those long-term benefits at risk; so [one must] weigh the costs, benefits, and risks carefully.”
When refinancing, homeowners restart the term of their loan. By extending the term of the loan, they are extending the time until property ownership. This means they could still be responsible for a mortgage well into retirement.
- The home secures a mortgage, and taking out more equity in the home could pose a risk to homeownership.
Unlike many other forms of debt, your mortgage is a secured loan, which means the loan is collateralized or secured by real estate. If a borrower defaults on the loan, the lender can foreclose on the home.
Dan Miller from Bankrate summarizes: “Because home equity loans use your home as collateral to secure the loan, it’s important to weigh the pros and cons of this type of borrowing carefully. A home equity loan could be a good idea if you use the funds to make improvements on your home or consolidate debt with a lower interest rate. However, a home equity loan is a bad idea if it will overburden your finances or if it only serves to shift debt around.”
- Home prices can fall, and homeowners can end up upside down on their mortgage.
Bair reports, “No one knows for certain where home prices are headed. Anyone who says otherwise may not have your best interest at heart.” She continues, “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.”
As mentioned, home prices have increased dramatically, and in California, home prices have risen 18.7% year-over-year as of June 2021. However, rising home values are expected to slow down. If a homeowner conducts a cash-out refinance, and then the home loses value, they could find themselves in a poor financial position. They may find themselves with less than 80% equity in their home, which would require them to begin paying an annual insurance premium; in worst-case scenarios, they may find they owe more on the home than it is worth.
- Refinancing your home is not free.
Homeowners considering a cash-out refinance will incur fees during the process. Bair points out that refinancing your home can cost between 2% to 5% of the loan amount. This means that if a homeowner takes out $100,000, they can expect to pay between $2,000 to $5,000. Additionally, if a homeowner has less than 20% equity in the home, they will be required to pay an annual insurance premium, ranging anywhere between 0.40% to 2.50% of the loan amount. However, Fannie Mae and Freddie Mac will not back a cash-out refinance loan with less than 20% equity.
Cash-Out Refinance vs. Standard Refinance
If you want to take advantage of current market trends, you could consider a standard refinance. A standard refinance, or rate-and-term refinance, allows homeowners to renegotiate their loan terms, providing them the option to reduce their interest rate and/or extend the length of their loan term. However, unlike a cash-out refinance, additional equity is not being pulled out from the home.
If you decide to pursue this option, Greg McBride, chief financial analyst at Bankrate.com, recommends the following rule of thumb: “If you can reduce your rate by half to three-quarters of a percentage point, it’s worth looking at … That’s usually the tipping point.”
Keeping Your Home Safe for your Future
According to experts, the bottom line is simple: Pull out equity from your home only if you can improve your overall position. Always proceed with caution and understand the risks associated with each option.