Archive for Sunday, October 6, 2002

Many homeowners overextending with cash-out refinancings

October 6, 2002

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It's awfully tempting all that money tied up in your house.

Why let it just sit there? Why not get it out and spend it on a vacation?

Hordes of American homeowners have pondered these questions and decided that they do indeed have better ways to use that money.

Suppose you owed $200,000 on a 30-year mortgage charging 8 percent. By replacing it with a 6 percent loan, you could borrow $245,000 and still pay the same $1,468 a month. After paying off the old loan, you'd have $45,000 to use for ... well, whatever.

Since the 6 percent interest would be deductible on your federal income tax, the real, after-tax rate would be more like 4 percent or 5 percent.

Cash taken out in refinancings is likely to exceed $100 billion this year, as it did last year, according to Fannie Mae, the government-authorized company that funds millions of mortgages a year. Cash-out refinancings have helped consumers continue spending, despite flat wages and stock losses.

What's wrong with all this?

Too many homeowners are getting overextended, and many people aren't considering long-term costs.

Fannie Mae helps keep the mortgage business going by purchasing mortgages from the original lenders and reselling them to investors in the form of bonds. In buying a mortgage, Fannie Mae takes on the risk originally born by the bank or mortgage company, while the company that sells the mortgage gets fresh cash to make new loans. Fannie Mae bought $270 billion worth of mortgages in 2001.

Fannie Mae sees problems in the tidal wave of refinancing and worries that its risks are too big. The chief danger is that the homeowner will default, or stop making mortgage payments.

Default rates are higher for cash-out refinancings than for ordinary refinancings. Fannie Mae says a borrower who takes a new loan that is 20 percent larger than the balance due on the old loan is three times more likely to default than a borrower whose cash out is 3 percent or less of the old balance.

In August, the default rate borrowers who were three or more months behind on their payments was 0.42 percent for all Fannie Mae loans. So projections, based on computer modeling, suggest the defaults on the biggest cash-out refinancings could approach 1.5 percent.

There are sure to be many more who are struggling to make their payments. High property values and low interest rates may make cash-out refinancings look appealing, but debt is debt.

It may be that many people who resort to cash-out refinancings do so because they already have financial problems and pose a default risk.

Fannie Mae says it will cover its additional risk by charging extra fees on cash-out refinancings.

Obviously, I think people should be very cautious about taking on bigger debts. You should have a really important need before sticking yourself with such a whopping bill.

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