NEW YORK (CNN/Money) -
The refinancing boom has plenty of homeowners feeling flush. After all, lower monthly payments put more money in your pocket. But skyrocketing home values during the past two years are also contributing to the real estate wealth effect.
Indeed, home prices rose a stunning 7.5 percent in June from a year ago, on top of a 6.3 percent spike during the same 12-month period in 2001. And since 1981, homes have appreciated about 4.2 percent per year, according to the National Association of Realtors (NAR).
Homeowners have been quick to tap that pot of gold, too, as the punishing stock market chips away at their once high-flying portfolios. To see if you could benefit from a refi, click here.
Well over half of all refinancings in 2002 have been cash-outs, which let you refinance your mortgage for more than what you owed. You pocket the difference and can spend the equity you "cashed out" as you see fit -- to pay off debt, invest for retirement, or even take a vacation.
You're typically allowed to have a cash-out loan of up to 90 percent of your home's value, according to Freddie Mac, but it's generally inadvisable to get one greater than 80 percent of your home's value. That's because someone with a loan-to-value ratio over 80 percent will have to pay some type of mortgage insurance, a second mortgage, or a home equity loan, said Doug Duncan, chief economist at the Mortgage Bankers Association of America.
During the second quarter of 2002, 67 percent of refis were of the cash-out variety, according to Freddie Mac, which defines a cash-out as one in which the new loan amount exceeds the old one by 5 percent or more. That's up from 61 percent in the first quarter of this year and 47 percent in the fourth quarter of 2001.
"People are saying, 'Hey, I've got that extra equity and I can go ahead and pull some of it out,'" said Keith Leggett, chief economist at the American Bankers Association.
Everybody's doing it
Still, a cash-out refi doesn't necessarily mean a free lunch.
It may ease strain on your short-term cash flow, but it also recasts debt and interest payments over a lengthy new mortgage term. And while mortgage interest may be tax-deductible, you have to think long and hard about the value of paying off your credit card, home improvements, tuition bill or a much-needed vacation over the next 15 or 30 years.
Shopping with home equity
Seventy-three percent of homeowners who opt for a cash-out refi use the money to wipe their slate clean of high-interest credit card or auto loan debt, according to NAR.
Using money from a cash-out refi to pay off high-interest debt can be a smart move, said Lawrence Yun, chief economist at the NAR. You'll still pay off that debt, but at better rates. Mortgage rates stand at 6.18 percent, as of the week ending Sept. 13 -- while the average credit card rate is about 14 percent, according to CardWeb.com. What's more, your mortgage interest is tax-deductible come April 15th; interest on your plastic (or auto loan) is not.
You also need to crunch the numbers, as you may -- or may not -- pay more in total interest for the original debt over a mortgage term, even though your cash flow may improve.
Say you carried $5,000 in credit card debt at a 10.5 percent APR, and you made only 2 percent minimum monthly payments. To wipe out that balance, you'd be paying that bill for about 17 years -- and you'd pay a total of $3,368 in interest. But if you refinanced a $150,000 mortgage for $155,000, and used the extra equity to pay off your balance, it would actually cost you nearly twice as much in total interest. The difference in total interest paid, at 6.25 percent, between a $155,000 loan and a $150,000 loan would total $6,083 over a 30-year term.
But if the APR on that same card were 16 percent, the cash-out refinancing would work in your favor -- making minimum payments would cost you $8,350 in interest over 26 years.
Finally, remember your own habits, said Leggett. Home equity may be useful in paying off a high-interest credit card or auto loan, as a one-time way to pay off debt, but it's all for naught if you run the balance up again. Keep charging and you'll be worse off than you were before.
Shopping with home equity
Consumers also pull cash out of their homes to remodel or improve them, said Keith Gumbinger, vice president of mortgage tracker HSH Associates. He considers home improvement a sound place to invest your cashed-out equity, because it offers a real return on money spent.
Investing in a retirement account, like an IRA, or putting a down payment on a second home might also be worthwhile ways to invest your cashed-out funds.
Homeowners often pay for college expenses with a cash-out refi as well, though Gumbinger argues a home equity line of credit (HELOC) might work better. (A HELOC lets you keep a certain amount of equity "on tap", like a bank account.) If you cash out $80,000 for college today, you'll start paying interest on it now -- but you may not need most of it until a few years from now.
Before you cash out, remember the downsides.
"The money from a cash-out refi shouldn't be withdrawn now for expenses in the future," Gumbinger said. "You start paying interest costs on the money now. If you don't need the money for four or five years, don't withdraw it preemptively."
|For more on real estate...
You'll have to pay for your purchases for the length of a new mortgage term. In general, you benefit more from a refi if you aren't too far along with loan payments. But if the end of your loan is in sight, you may not want to handcuff yourself to new payments for another 15 or 30 years.
Avoid falling into a "serial refinancing" trap, too -- don't keep pulling cash out of your home as a steady supply of pocket money. It's always good to have some equity to leverage in case of an emergency. If you cash out equity routinely and spend it mindlessly, you won't have it when you might need it most -- if you're facing an emergency like a layoff, say, or a hospital stay.
Also, Fannie Mae, which owns over half of all cash-outs, raised its rates in late September to stem the tide of big dollar refis. Research revealed that homeowners who refinanced for 20 percent more than their old balance were three times more likely to default than someone who cashed out just 3 percent more than their balance.
That means most Fannie Mae-owned cash outs now have an additional ½ point upfront fee - or more.
A drop in home values?
Another thing to consider before you start emptying out all the equity in your home is the state of the housing market in your area. Sure, rising prices are great -- but it's also prompted talk of a possible housing bubble in some sections of the housing market (or even nationwide).
"Part of the reason home prices have risen may be that mortgage rates are so low," Leggett said. "People feel they can afford bigger payments, so they bid more. If rates rise, people won't bid as high. Some segments of the market could become soft, more likely higher-value homes."
A deflated bubble -- or even a modest drop in the value of your house -- could make the cost of your loan exceed the value of your home. That's not good.
"If you're not moving, [that's] not necessarily a huge problem," Leggett said. "But if you sell your home, you have to pay off a loan that's greater than what you'll get, especially when you start factoring in real estate agent fees and closing costs. You could end up hurting."