Here We Go Again: Cash Out Refinance

Recently I read an article in the Wall Street Journal titled: “Homeowners Are Again Pocketing Cash as They Refinance Properties” (subscription required). My first thought: Here we go again.
 
Unfortunately, the article was mostly positive on the development, as the writer’s take was that this reflects confidence in the economy and relative job security. I have no idea if this bodes well for the economy or not (although my intuition says it’s a negative), but on an individual level I think this is a really bad idea. There are no absolutes in personal finance, and everyone’s situation is different. With that caveat out of the way, lets look at why taking cash out of your home when you refinance can be a poor financial decision.

Your home is a good store of value:
Since a portion of your house payment goes towards paying down your mortgage, you automatically increase your home equity over time. When you add in home price appreciation, this represents a good store of value. To be clear, a home that you live in is not an investment. You cannot expect to earn a positive return over a reasonable timeframe by paying off your house, but it can be an excellent store of value. Since most people pay their mortgages on time, you are guaranteed to have a portion of each payment available as home equity in the future - as opposed to renters where their payment does not build any equity.
 
For the average American, this is very important. According to US Census information, home equity represents the bulk of most households’ net worth. It varies by age and income, but for older Americans on average, home equity represents upwards of 80% of their net worth. Needless to say, if you raid this piggy bank now, it won’t be there when you are older and may potentially need it for retirement or some other urgent personal need.
 
Home improvements are a good use of money:
The math on this is pretty straightforward. According to Remodeling Magazine, two popular home renovations, bathroom remodels and kitchen remodels, recoup 65% of their costs. This means that if you spend $100,000 on your remodel, you will increase the value of your home by $65,000. If your home price appreciates by 3% per year, to fully recoup your cost would take 14.5 years. This certainly is not the worst use of home equity funds, but it will certainly leave you less well off financially than when you started.
 
Pay off high interest credit card debt and save some cash:
​This is one of the worst ideas. And it was specifically mentioned in the WSJ article, which is disappointing. At first glance, this may sound like a great option, but it can be fraught with risk. At the most basic level, credit card debt is unsecured debt. This means that you have received this credit on your good word that you will pay it back. It is not secured against any assets that you own. If you neglect to pay, you will wreck your credit score (thus being ineligible for any more unsecured credit), and you will get lots of phone calls from your credit card company (and later collection agents), but the lender has no recourse to force you to pay. A mortgage is a secured debt - it is backed by your house. If you neglect to pay your mortgage, the bank can and will foreclose on your house. Trading unsecured debt for secured debt backed by your home reduces your financial flexibility and leaves you in a more precarious situation. There are certainly instances where financially disciplined people have gotten into significant debt due to layoff, medical issues, or some other life event that has thrown them for a loop. A person in that situation who gets themselves back on solid financial footing may be able to use home equity as viable tool to help pay off debt – but only if they never run up their credit card balance again. The data indicates that most people will simply run up their credit card balances once they are paid off. Solving the underlying spending and saving issue is the only thing that will permanently eliminate your credit card debt.
 
The financial recovery has finally gotten to the point that homeowners have accumulated significant equity in their homes again. This is certainly a great situation to be in. But, given the heartbreaking situation where many people lost their homes during the last crisis, it would be a shame to think that we have not learned any lessons about using our homes as ATMs. Let’s hope that this article isn’t the canary in the coal mine.

For more information on these topics:
Fun with Mortgage Math
​Debt Is Bad … but These Debts Are Terrible​