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I hear a lot of chatter about a boom in cash-out refinances, and the presumption seems to be that this is destined to wreak havoc on the housing market and the economy at some point. Cash-out loans have been growing over the past few years and it is also true that we have a recent history of excessive equity extraction factoring in a bust in housing.
But there are several critical reasons why the recent uptick in cash-out refinancing is nothing like the cash-out boom of the early to mid-2000s
First, the refinance boom’s main driver in the 2000s was unhealthy because of the marketplace’s speculative unhealthy lending standards. Home prices were growing at an unsustainable level from 2002-2005, leading to some excess risk-taking on inadequate loan debt structures.
In the 2020 market, on the other hand, refinances were not driven just by an increase in equity but lower mortgage rates. Cash-out loan borrowers who increased their loan balances could get a more favorable rate than in previous years. Although mortgage refinance activity was the highest in 2020 than it has been since 2003, the reasons for refinancing and the quality of the equity loans are much different than they were in the 2000s.
The graph below is from an article by Len Kiefer of Freddie Mac. This is an excellent article for those interested in diving into the minutiae of the 2020 refinance market.
If we dig a little deeper into homeowners’ balance sheets, we see that since 2010, cash flow and loan quality of mortgage holders were excellent.
Although homeowners built strong equity positions, they tended not to cash out on this equity as much because they simply didn’t need the money. COVID-19 changed that. What COVID-19 did was take mortgage rates below 3.5%, and that meant homeowners could, in theory, cash out on their home and have a lower mortgage rate than their current level. Remember, it took time to get rates properly lower, and for a brief while some lenders didn’t even offer favorable cash out loan rates and some credit did get tighter early in the crisis. However, in time, the downward push in mortgage rates created more demand than in the pre-COVID years for cash-out loans.
The second factor we need to consider when comparing the current uptick in cash-out refinancing and the previous boom is that today, homeowners aren’t borrowing much compared to the amount of nested equity in their homes. Per a recent report from CoreLogic, roughly 1.5 trillion dollars of equity was created by American homeowners last year alone.
The third factor to consider when analyzing this issue is the debt structure of current mortgage loans compared to the 2000s
The total amount borrowed in the previous year was nothing compared to the equity built. According to Freddie Mac, and here again I reference the article by Len Kiefer mentioned above: “In the fourth quarter, homeowners cashed out only approximately 0.25 percentage points of available equity through a cash-out refinance, far less that the over 0.5 percentage points extracted in 2006.
Remember, too, that current market conditions are such that we can expect mortgage rates to rise as the economy improves. When mortgage rates rise, cash-out loans and refinances will lose their appeal, so this so-called boom in the cash-out market is destined to be short-lived.
Fixed low-mortgage rates locked and an improving economy means we have homeowners with fixed low debt cost along with rising wages. Rising wages are one of the main reasons why those who predicted a housing collapse due to COVID-19 got it wrong.