The American Enterprise Institute (AEI) Housing Center and the Center for Responsible Lending (CRL) have jointly prepared a brief on the pitfalls of cash-out refinancing in a rising interest rate environment.
Based on our analysis of both public and proprietary data, we share a common concern: Cash-strapped borrowers are being enticed into using the home equity they have accumulated as an ATM. With today’s higher mortgage interest rates, taking out these first-lien, cash-out refinance loans will damage their long-term financial health.
We are particularly concerned by trends and distributions for Federal Housing Administration (FHA) and Veterans Affairs (VA) programs, which typically serve minority, low-wealth, lower credit score, and veteran homeowners. Accordingly, we focus our discussion on the FHA and VA programs and the borrowers they serve.
Second Liens Are Better
Cash-strapped homeowners struggling to cope with high inflation and lagging wage growth are being enticed by cash-out refinance offers of easy access to their home equity, which increased dramatically during the pandemic.
Although at one time such cash-out refinances were relatively low cost because the new rate was less than, or just slightly above, the borrower’s current rate, in today’s environment, refinancing means substituting a new, higher interest rate that can be two to four percentage points above one’s existing rate.
Our research demonstrates that this can have serious longer-term repercussions for the financial health of vulnerable borrowers. For example, the typical cash-out refinance completed in late 2022 by a borrower with an FHA or VA mortgage provided about $36,000 in cash but will add about $42,000 in additional interest on the existing mortgage balance over the first seven years (not including interest on the new cash itself or the closing costs on the new loan).