The Pitfalls Of Cash-Out Refinancing In A Rising Interest Rate Environment

Second-lien home equity loans are a far better way to take out cash

Pitfalls Of Cash-Out Refinancing

In the current interest rate environment, second-lien home equity loans are a far better way to take out cash from home equity. Second-lien home equity loans were designed to enable homeowners to convert home equity into cash without having to refinance the entire mortgage.

Even though the interest rate on the new cash is higher with a home equity loan than with a cash-out refinance, that higher interest rate applies only to the new cash. Therefore, when cash-out refinance rates are above borrowers’ current mortgage rates, the overall cost of the home equity loan is much lower because the borrower continues to benefit from that lower original mortgage rate - a substantial savings, as noted earlier. This factor more than offsets the higher rate of interest paid on the new cash from a home equity loan.

The typical FHA or VA borrower who completed a cash-out refinance in late 2022 would have paid $38,000 less in total interest and accumulated $42,000 more in home equity had they been able to obtain a 10-year home equity loan instead. Further, because closing costs are a percentage of the loan balance, the typical FHA or VA borrower who completed a first-lien, cash-out refinance paid three to four times more in closing costs than they would have for a second-lien home equity loan.

Many mortgage lenders, while willing to make new mortgages that the government will guarantee, such as cash-out refinances that are backed by the FHA or VA, appear much less willing to make home equity loans, especially to lower credit score borrowers. Given that interest rates now favor the home equity loan as a cost-effective means to tap home equity, the market now has the opportunity to provide these loans.

At the recent rate of about 13,000 FHA and VA cash-out refinance loans per month, about 160,000 of these homeowners could become saddled with more costly mortgages this year.

Lenders should make second mortgage products such as home equity loans and home equity lines of credit (HELOCs) more available. Of particular concern is the fact that FHA cash-out refinances are disproportionately going to financially vulnerable borrowers, including those with lower credit scores and borrowers in neighborhoods with higher shares of Black residents.

About the author
This brief was written by Tobias Peter, research fellow and assistant director, AEI Housing Center; Edward J. Pinto, senior fellow and director, AEI Housing Center; Mike Calhoun, president, Center for Responsible Lending; and,…
Published on
May 02, 2023

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