NEW YORK (CNNfn) - More and more homeowners who refinance their mortgages are borrowing against the equity in their homes, according to a recent study. It's a tempting way to generate quick money, but consumer advocates say homeowners should think long and hard before jumping at the cash.|
A report by mortgage consolidator Freddie Mac this week finds that 59 percent of homeowners who refinanced in 1999 took out a loan on their equity, the value they own in their house. That means they traded in their old mortgage for a new one at least 5 percent greater than the original loan. That's up from 48 percent of refinancings in 1998.
Strong housing market explains part of the trend
One reason for the shift is that the strong housing market has pushed home prices up fairly rapidly. In the third quarter of 1999, the latest figures from Freddie Mac, the average home increased at an annualized rate of 7.2 percent. That's up from an annualized increase of 6.0 percent the same quarter in 1998. Both increases are well above inflation, so homeowners gained real value just for holding on to their property.
Not surprisingly, the homes people chose to refinance had increased even more, growing a median 13 percent in value in 1999. That means those who refinanced had more equity to borrow against than the average homeowner. The median appreciation for a refinanced house in 1998 was 10 percent.
So more homeowners have decided to take out some of that gain and spend it elsewhere. Freddie Mac doesn't track what the homeowners do with the money. But Americans spent $94.7 billion on remodeling their homes in 1999, according to Harvard University's Joint Center for Housing Studies. That's up 4.5 percent from the year before.
It stands to reason some of the money ended up in home improvements. There's also a technical reason why the number of those taking out equity is rising as a share of refinancings, according to Washington, D.C.-based Freddie Mac, officially Federal Home Mortgage Corp., which buys mortgages from banks, then sells them as mortgage-backed securities.
The technical explanation? After a boom in refinancings to get lower mortgage rates in the first half of 1998, that type of refinancing has dried up because mortgage rates have been rising, though they dipped this week.
So those who refinanced to take out equity -- to spend money, in other words -- accounted for a greater share of refinancings than those who refinanced to get a better mortgage rate -- to save money.
Rate much higher than in prior boom
Still, it's a stark reality that almost two-thirds of refinancings leave homeowners with less value in their houses. Even in the last refinancing boom, back in 1993, only a third of borrowers who refinanced drew out equity.
"Homeownership is one of the most valuable investments an individual or family can make," pointed out N'ann Harp, president of Smart Consumer Services Inc., a consumer-education and advocacy group in Crystal City, Va. "Anything that undermines that investment can destabilize a family's financial foundations."
A house is often the most expensive purchase people make in their entire lives, and they had better have a good reason for reducing the value of that big purchase, consumer advocates like Harp say.
Taking equity out can make sense
It might make sense to pull out some of the equity gains if you believe you can generate a higher return on the money elsewhere. Some people also refinance a mortgage to pay down higher-interest debt.
Richard Roll, president of the American Homeowners Association, pointed out that credit-card debt runs at a much higher interest rate than a mortgage. Mortgage interest also is tax deductible, unlike credit-card interest.
Perhaps some investment-savvy homeowners took home equity and put it in the stock market, figuring they could beat that 7.2 percent average gain in home prices. The S&P 500, for instance, rose 19.5 percent last year. 1999 was the fifth year of double-digit gains, outpacing the gain in home prices. If precedent holds, homeowners' money is better off there than in their home.
There might be other reasons for borrowing against the value in your home -- paying for your kid's college, say. Even home improvements may pay off in the long run, and you get to live with the results.
But homeowners should take equity out only to make a long-term investment with the money, mortgage experts say, because they'll pay for any equity they take out for the life of their mortgage. The average refinancing in 1999 was on a mortgage that was 5 years and two months old. On a 30-year fixed mortgage, you'll be paying for just under 24 years, 10 months.
Short-term reasons aren't good ones
So, yeah, it's tempting to take some of that home-equity gain and blow it on a Caribbean cruise. But you will pay for that decision for the duration of your mortgage. With interest, you will likely pay much more than the value of your vacation over time.
There's another significant risk: Home prices do go down. If you hit a bad housing market and you've borrowed against your equity, you may find what's left dwindling away. That's a possibility as baby boomers get older, see their families leave, scale down their housing needs and finally retire. "Once that kicks in, there's going to be a down trend in home pricing," Roll said.
In the worst housing markets, homeowners find themselves with "negative equity," where the amount they've borrowed is more than their house is worth. Each payment puts them further in the hole. If they've borrowed against the equity, they've compounded an already horrible situation.
Think before you refinance
Borrowing against home equity "is an attractive and easy way to borrow," Harp said. "It's tempting, but it may not be the best decision."
Think before you refinance, she advises, and consider these issues:
- Making regular mortgage payments is a commitment to your future and to financial stability.
- Home-equity-loan abuse is easy money for unscrupulous lenders. There has been an "alarming increase" in abuse, Harp said, and consumer protection is still weak in most states.
- Watch for hidden or excessive fees, for items like processing, underwriting or loan underwriting. Such fees can amount to 8 to 10 percent of the loan value. They quickly reduce the value of your investment.
- Watch for add-on fees. "Required" or "packed-in" add-ons such as for life insurance or other small monthly items create an extra burden without adding any real value.
- Watch for lenders who prey on people with poor credit who own their own homes. You've seen the ads on TV. Such "subprime lenders" that promise quick cash if you're in financial trouble but own your home often charge exorbitant rates. Unsuspecting families are sometimes even forced into foreclosure through such loans.
- Consider alternative borrowing options before jeopardizing the hard-earned equity in your home. Many lenders offer loans that don't require you to undermine your biggest investment.