November 4, 2006
Mortgage Lesson No. 1: Home Is Not a Piggy Bank
By DAMON DARLIN
Economists are fond of pointing out that "there ain't no such thing as
a free lunch." But for several years, as interest rates have fallen,
homeowners have gotten something pretty close to it.
Anyone who had been diligently paying down a mortgage and others who
had just sat back and watched their home appreciate in value were able
to refinance and take out the difference between the value of the home
and what was still owed, known as equity. Not only did they remove the
increased equity in the home as cash, most people were paying lower
"People have literally picked up their house at the foundations and
shook it upside down like a piggy bank," said Ed Smith, chief
executive of the Plaza Financial Group, a mortgage brokerage firm in
La Mesa, Calif., near San Diego.
Since January 1999, according to figures compiled by Alan Greenspan,
the former Federal Reserve chairman, and James Kennedy, a Fed staff
economist, in a Federal Reserve Board paper, more than $2.62 trillion
has been extracted by homeowners through refinancing and home equity
But as rates have gone up, the extraction has continued. In the first
six months of this year, even with interest rates rising, more than
$511 billion was extracted from homes through cash-out refinancing and
home equity loans, and that was more than the amount taken out for all
of 2005, a record year for mortgage equity extraction.
More homeowners did cash-out refinancings in the third quarter of this
year than at any time since 1990, according to Freddie Mac, the
mortgage company. Many of them, Freddie Mac said, were scrambling to
get out of interest-only mortgages that will soon reset at a higher
"A lot of folks are squeezing out the last bit of equity from their
homes," said Celia Chan, director for housing economics at Moody's
Economists argue over what effect that money, which they call mortgage
equity withdrawal, has had on consumer spending. Homeowners cash out
to pay off more expensive credit card debt, remodel the house to build
more equity, or just have fun. They may very well have used it to buy
another house or not spent it at all, but added it to savings.
Economists really are not certain.
"I guess it is one of those mysteries," said Christopher D. Carroll,
an economics professor at Johns Hopkins University. "I don't think
anyone knows what the answer is."
Nevertheless, mortgage equity withdrawal is closely watched as an
indicator of the general economy because, Mr. Carroll said, "there is
a lot concern that a cooling housing market could result in a sharp
fallback in consumer spending."
A recent paper that Mr. Carroll helped write contends that for every
$1,000 change in housing wealth there is an immediate propensity to
consume about $20 more. The wealth effect, as the phenomenon is
called, is twice as high for housing wealth as it is for stock wealth,
Mr. Carroll and his associates said.
Economists will argue for many years to come how much a decline in
home prices damped consumer spending. But this much is already clear —
it is a lot more expensive to tap home equity. It is one reason
economists predict consumer spending will slow in 2007 and even more
The slowdown is already being seen in home remodeling. The Joint
Center for Housing Studies at Harvard found that over the last 12
months homeowners have spent only 1.6 percent more on remodeling
projects than they did in the preceding 12 months. That rate was
running at close to 20 percent throughout 2005 and the first four
months of 2006.
Homeowners with equity built up in their home can still get at it, but
it is no longer free money. Unlike the situation five years ago, when
a person seeking to refinance heard the same thing from nearly every
mortgage broker and lender — do it! — now the advice is varied.
The best thing to do in most cases is to leave the equity alone. No
one expects home prices to appreciate sharply. A cautious consensus
among economists is developing that prices will decline in some areas,
but that the depreciation will not be sharp or prolonged. But should
home values fall, a homeowner who has depleted the built-up equity
risks finding himself paying a mortgage on a home that is worth less
than the mortgage.
There is another change in the market that could block a homeowner's
desire to borrow against the increased value of the home. "Lenders are
being very cautious today as they do appraisals," said Patty McGill,
president of Money Marketing, a mortgage broker in Frederick, Md.
"They are scrutinizing appraisals so they are not lending on phantom
She said she had done very little equity extraction business recently.
These mortgages carry higher interest rates than first mortgages
because lenders view them as riskier. It is usually about two
percentage points above the prime rate. Right now you can get one for
about 9 percent to 10.25 percent compared with borrowing at about 6
percent on a fixed 30-year loan.
Sometimes, and a homeowner has to analyze this carefully because it is
not always the case, a homeowner might be better off refinancing the
first mortgage than taking out the home equity loan, even if that
means refinancing at a higher interest rate.
If you have a mortgage at 5 percent, why would you give it up for an
even larger one at 6 percent? Opinion is divided on this issue. Mr.
Smith, for example, is an advocate of the "blended rate," the
marketing term lenders use for paying an interest rate that is higher
than the one on the first mortgage, but lower than a second
mortgage's. But the fact remains that it will cost homeowners more.
"If you reach out to tap equity, but can't afford to make the
payments, what use is it?" Mr. Smith asked. "Most people's income has
not grown to allow them to tap it. If you pull money out," you have to
pay for it eventually.
Some mortgage brokers say that some homeowners become obsessed with
the low interest rate they are paying on their first mortgage and do
not realize that a new first mortgage might be cheaper than adding the
home equity loan. "We call that low rate the 'cocktail rate,' because
it is the one people brag about at cocktail parties," said Neil
Sweren, president of the mortgage brokerage company Allymac Mortgage
Services in Owings Mills, Md.
He is recommending a 30-year loan, with the payments in the first 10
years being interest-only. Take a homeowner who borrowed $425,000 a
number of years ago to buy a home that is estimated to be worth about
$620,000. The homeowner has convinced himself that he should use about
$75,000 of that increased value to fix up the house, where he intends
to stay for 10 years.
The homeowner could pay about $562 a month to borrow the money in a
home equity loan.
In Mr. Sweren's plan, he would trade in the original $425,000 30-year
loan with a fixed rate of 5.5 percent on which he had been paying
$2,413 a month. He would borrow $500,000 at 6.5 percent. Under the new
first mortgage, the monthly payments during the first 10 years would
be $2,708, or $295 more than the old one, a 12 percent increase.
Of course, without the interest-only feature, that payment would be
another $452 a month.
In the 11th year, the payment jumps to $3,727 a month for the next 20
years. In that period the entire loan must be paid off. The homeowner
pays $567 a month more than he would have paid with a conventional
If it sounds like a losing proposition, you are not alone in that
opinion. Still, Mr. Sweren said the larger the overall debt, the more
sense it makes to arrange a refinance rather than a home equity loan.
Most people are not going to go for deals like that and will leave the
piggy bank undisturbed.
Ms. Chen, the economist, predicts that there will be a lot fewer
equity withdrawals in 2007. "I don't think there is a compelling
reason to extract equity at this point," she said. "People will just