The still increasing level of cash-out refinancings come at a steep price - since almost all are refinancing into a higher interest rate than their current mortgage.
Say a person has a $500k mortgage, and takes $100k out with a new $600k mortgage at a rate 2% higher than their current mortgage. They're paying the interest rate on the $100k cash-out (today that's 5.75% on a 5/1 ARM), and in additon, paying an extra $8k per year in higher interest rate on their existing mortgage.
To borrow that extra $100k cash-out they're effectively paying 13.75%! Even my Visa credit card only charges 8.9% if I were to ever borrow money, which I don't.
Its a shock that mortgage credit creation is still rising. It shows how badly people need the additional money from debt to maintain their spending level.
Homeowners are paying more to cash out
Detroit Free Press -- August 13, 2006
freep.com
WASHINGTON -- Remember when you refinanced your home mortgage to get a lower interest rate and pay less every month?
How quaint. And how utterly out of date. Now the rage is refinancing into a higher interest rate -- yes, you read that correctly -- while pulling out buckets of fresh cash.
Almost nine out of 10 homeowners who refinanced during the second quarter of this year cashed out additional money -- often tens of thousands of dollars or more -- according to mortgage investment giant Freddie Mac. The 88% cash-out refi rate was close to the all-time record, and the rate could surpass the record later this year.
Meanwhile, the typical refinancer hasn't been scouring the market for an interest rate lower than his or her existing first mortgage. To the contrary, according to Freddie Mac, most refinancers are opting for larger replacement first mortgages with rates averaging about one-half percentage point higher than on their old loan.
A familiar situation
Cash-outs may be booming, but they are not a new phenomenon. They've existed for years as a financial tool to extract equity tied up in real estate and to convert it to immediately spendable money. During the refi boom years of 2003 and 2004, for example, anywhere from a third to a half of all refinancers pulled out some additional cash. However, the overwhelming majority of borrowers during the go-go refi years chose traditional rate-reduction replacement mortgages in which the new balance approximated the old balance, and the new monthly payment was lower than the old.
What's new this time
Scroll ahead to mid-2006: Short-term interest rates no longer hover near 4%. Thirty-year fixed-rate first mortgages no longer are in the 5's. Now the prime rate is 8 1/4 % and could move higher. Standard 30-year mortgage rates are nudging 7%. Home equity credit lines are slumping as their adjustable rates -- typically set one or more points above the bank prime -- start racking up bigger costs.
Now consider the near-record pace of cash-out refis: Say you need $40,000 to $100,000 for a home improvement, a business investment, a down payment on a vacation property or to consolidate high-cost consumer credit debts. Say you also have lots more than $100,000 sitting untouched and frozen in home equity. Rather than signing up for a home equity credit line tied to a jumpy and unpredictable prime rate plus 1%, you opt for a fixed-rate cash-out refi.
In effect, you trade in your existing first mortgage -- say it's at 6 1/4 % -- for a replacement at 6 3/4 %. Plus you pull out the money you need and add it to the principal balance of the new loan. Yes, your monthly payment will be higher than you were paying on the old loan, and yes, you'll have transaction costs, which you might be able to roll into the new loan amount. And yes, your total first mortgage debt may be significantly higher than it was.
But then again, would you be happier with a $100,000 credit line with a floating rate potentially heading for double digits?
Getting out of adjustables
Amy Crews Cutts, Freddie Mac's deputy chief economist, says another factor at work in the big shift to cash-out refis may be the estimated $500 billion in adjustable-rate first mortgages that will experience rate resets this year, plus another $650 billion in second mortgages and equity credit lines that will adjust upward.
Many homeowners want out of these mortgages -- especially those with 40% and 50% payment increases at the first reset. Refinancing into standard fixed-rate loans suddenly looks attractive. And if homeowners can pull out some cash in the process, that's fine, says Cutts, since "many people see that their real estate has been one of the only things making money for them during the past few years." Plus they have confidence that home real estate remains a solid investment -- even in the face of a slowdown in appreciation rates, she says.
Another key to the cash-out refi boom, according to Cutts: "Borrowers have developed new ways of thinking about their home mortgages," and increasingly see them as positive resources -- not just debt loads -- to be used to achieve other personal financial objectives.
Is a cash-out for you?
Should you consider a cash out? Not unless you have a good reason: you really need the money, you don't want to play roulette with an adjustable-rate equity line, you want to lock in your mortgage debt at a relatively low long-term fixed rate. Check out fixed-rate second mortgages as well. They may have lower transaction costs, and some banks are pricing their rates on seconds to compete directly with cash outs.
KENNETH HARNEY, based in Washington, writes on national housing issues. His e-mail address is kharney@winstarmail.com.
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