Think Twice About A Cash-Out Refi

Six months later, you lose your job, and, strapped for cash, you start running up your credit cards again. Soon you fall behind on your mortgage, the bank forecloses, and you're forced to move in with mom and dad.

Sound far-fetched? Credit counselors say it happens all too often. Homeowners are taking advantage of low interest rates and rising home prices like never before, converting their equity into cash to help pay off other debt and fund future spending. While they might feel like they've just won the lottery, they're merely swapping one kind of debt for another. And they're putting up their homes — their greatest assets — as collateral.

"People are falling over themselves to get equity out of their homes," says Steve Rhode, president of Myvesta.com. "But just because they can doesn't mean it's a good thing."

The industry calls this sort of transaction a cash-out refinance. Think of it as a regular refi with a home-equity-loan kicker. Here's how the process works: When a homeowner refinances, he or she adds to the balance remaining on the original loan. The amount is usually limited to 85% of the home's appraised value — but, for a higher fee, some lenders will allow amounts up to 125%. At closing, the homeowner receives a lump-sum check for the extra cash. Whoopee!

Cash-out refis are so prevalent these days that Freddie Mac, which has a 17% share of the home-loan market, says more than 40% of its refinancing customers during the fourth quarter of 2002 added at least 5% to their original loans. For all of last year, Freddie put $90 billion in cash in the hands of its refi customers.

Experts agree that when interest rates are as low as they are today (the average 30-year fixed-rate mortgage sits at 5.4%), tapping home equity to pay off higher interest debt, such as credit cards, can be smart. Not only will borrowers get the creditors off their back, but the interest they're paying is tax deductible, to boot.

But debt is debt, and there's always the danger that cash-out-refi borrowers will overextend themselves. Should some unforeseen event, such as a job loss, occur, they might be forced to sell their home and walk away with a smaller profit, just to get out from under their crippling monthly payments. And consider the worst-case scenario: The seller has borrowed so much against his home that he can't fetch the price he needs to cover his new mortgage plus the roughly 10% in fees (realtor commissions, closing costs and so on) it takes to sell his home. If he can't cough up the difference, he won't be able to sell. And if he becomes seriously delinquent on his mortgage payments, the bank will foreclose.

Borrowers who live in highflying real-estate markets should be especially wary of cash-out refis, since their houses could be worth less a year from now than they are today. Already, home price appreciation is expected to slow dramatically in parts of the Midwest, including Illinois, Michigan and Ohio, which have seen higher rates of delinquencies owing to manufacturing-job losses. Other states, such as California, Florida and Colorado, appear "bubbly," or ready to deflate, says Celia Chen, senior economist with Economy.com, a West Chester, Pa.-based independent economic consultancy.

The folks at Freddie Mac and Fannie Mae are concerned, too. Earlier this year they raised their fees on cash-out refis to cover future anticipated losses, since these loans have a higher likelihood of foreclosure. "Historically, we have seen cash-out refis not perform as well as rate-and-term [or traditional lower-rate refis] and new purchases," says Amy Kutz, deputy chief economist for Freddie Mac. "So we have to be careful about what's likely to happen in the future." Kutz says Freddie Mac expects a weak economic recovery, uneven job growth and moderating home values in the next year. "It's a good time [for lenders] to be prudent," she says.

Homeowners should act prudently as well. Here are a few things to think about before converting your equity to cash.

Internal Audit
Your first step should be to conduct an internal audit of your household balance sheet, including all of your assets and debt. If you don't have a stash of cash ready to bail you out of an unforeseen financial hiccup, don't even consider a cash-out refi, says Freddie Mac's Kutz. While the unemployment rate is still relatively low, new layoffs are announced daily, and job creation is barely keeping up. So unless you have a rainy-day fund, you should consider alternative solutions for paying your bills. For more, visit our debt-management center.

Paper Money
As we mentioned earlier, how much you can borrow depends on your home's appraised value. Be warned: No one really knows what a house will fetch until a buyer and a seller agree on a price. The only way a bank can estimate your home's worth is by bringing in an appraiser to evaluate the property. The problem: Many appraisers are more willing to cater to lenders' interests than to yours. The higher the appraised value of your home, the more perceived equity you have at your disposal, and the richer the potential deal for the bank. Many appraisers play this game. "There is an incentive to make the deal go through," says Freddie Mac's Kutz. "So pay attention if [an appraisal] sounds too good to be true."

Remember: Paper wealth isn't the same as real wealth. Don't be fooled into thinking otherwise. For a more accurate estimate of your home's worth, go to open houses and see what neighbors are asking for comparable properties, and search through county records for recent sales. If your appraised price seems too good to be true, it might be worth your while to bring in your own appraiser for an unvarnished opinion.

Don't Get Greedy
Don't borrow a penny more than you need. Loans that add 20% to the original balance are three times more likely to end in foreclosure than are loans that add just 3%, according to Fannie Mae. So rather than seeing how much the bank will lend you, identify how much debt you wish to pay off or how much a project will cost, advises Rudy Cavazos, a spokesman for Money Management International, a Houston-based nonprofit credit-counseling service. While it might seem tempting to borrow an extra $10,000 for a family vacation, it's a foolish move. "That money will run through your hands quickly, and you'll be left paying off the interest for years," says Cavazos.

Regional Problems
As we said earlier, some local real-estate markets are riskier than others. Watch out if prices in your area have increased too quickly compared with the underlying economic fundamentals, such as income growth, job growth and population growth, says Economy.com's Chen. And make sure your area isn't dependent on just one major employer. Two regions that come to mind, she says, are Denver and San Jose, Calif. Now that the tech boom is over, job growth has all but disappeared in those locales. So if you live there, it's critically important to be conservative and borrow only what you absolutely need, since demand for homes could slow and prices could plunge