Housing industry experts have been pretty vocal about the benefits of refinancing a mortgage lately, saying homeowners can benefit from current low interest rates to save potentially hundreds of dollars a month on their loan repayments.
But Sheila Bair (pictured), chair of the board of directors at Fannie Mae this week warned that refinancing is not always the smart option, and that homeowners need to be careful about taking out too much of the equity they have built up in their homes.
Refinancing has surged over the last year as home prices have seen double-digit gains, boosting the equity people have in their homes. A cash-out refinance allows a homeowner to take out some of that equity by restructuring the terms of their mortgage, giving them more money in their pockets as well as cheaper monthly repayments.
Fannie Mae and Freddie Mac data shows that U.S. homeowners cashed out a combined $185 billion in equity by refinancing in 2020, the highest amount since 2007.
Bair wrote in a column for Yahoo Money that cash-out refinancing can make sense for homeowners in some instances. For example if a family needs more cash to cover medical expenses or to pay for a home renovation or college tuition.
“But cash-out refinances can also carry risks that every homeowner and every lender should consider, especially during times of rapid price increases such as now,” she warned.
The big risk Bair referred to is that home prices won’t rise indefinitely, and so anyone who cashes out at the peak will see their home’s value fall below that of their loan’s value. In other words, they will have to pay back a loan that is more expensive than what their home is actually worth.
There are in any case much stricter rules on refinancing than before. Prior to the Great Recession it was pretty simple for most homeowners to take out some equity, but these days it’s much harder. Fannie Mae for example now requires that cash-out refinance loans are no greater than 80% of the home’s value. It also requires a minimum of six months of verified reserves for homeowners whose monthly debt payments are 45% or more of their incomes.
Homeowners and lenders are being more cautious anyway. During 2020, 36% of cash-out refinances resulted in a mortgage balance at least 5% greater than the previous balance. From 2005 to 2008, that comprised 78% of all refinances.
“The overall picture of today’s cash-out refinance market is one calling for caution, but not alarm,” Bair said.
Homeowners who are considering a cash-out refinance need to recognize the importance of not missing any monthly payments on their home, Bair said, as this will work against them when it comes to factoring the new monthly premium they have to pay. In addition, homeowners must be aware that cash-out refinancing isn’t cheap, with closing costs of between 2% to 5% of the loan amount. Fannie and Freddie also refuse to back cash-out refinance loans for homeowners with less than 20% equity.
“Homeownership can be one of the most effective ways of building wealth,” Bair continued. “However, entering into a long-term mortgage and building equity requires care and diligence.”