The parade to refinance

With interest rates hovering near 30-year lows, it comes as no surprise that more and more people are refinancing their mortgages.

The move can lower monthly payments, reduce the length of a current mortgage, or both.

But lately, most people are refinancing for another reason: to put cash in their pockets. Home prices keep surging, and people are getting at the mounting equity in their homes through "cash-out" refinancing – obtaining new loans at least 5 percent larger than the balance of their existing loans. Nearly 7 in 10 of the loans refinanced by mortgage giant Freddie Mac in the second quarter of this year were cash-out deals, a 9 percent increase over the same period in 2001.

Frank Nothaft, chief economist for Freddie Mac, says that by year-end, homeowners will have taken out as much as $100 billion in equity from their homes. This is a slightly slower pace than that set in 2001, when about $140 billion was cashed out.

Rising home values – one of the few financial positives in many Americans' lives of late – makes the strategy hard to resist.

Say you bought a $150,000 home three years ago and took out a $135,000 mortgage. Today that home might be worth $200,000, and the mortgage would have been knocked down to $130,000. You decide to refinance at a lower interest rate, but instead of covering only the amount you owe, you borrow $160,000. As a result, $30,000 winds up in your bank account, perhaps earmarked for college payments or a new kitchen.

What that means, of course, is that US homeowners own increasingly less of their homes. The amount of home equity held by Americans with mortgages is dropping to dangerously low levels, says economist A. Gary Shilling. Twenty years ago, the average equity was 30 percent, says Mr. Shilling. Today it stands at about 16 percent.

That could be a problem if real estate prices deflate, as many experts say will happen if the economy takes another big dip. Shilling is among those predicting a decline over the holiday season, as more consumers hold off on purchases and as employee layoffs continue to build. Homeowners, Shilling and others say, may find themselves owing more than their homes are worth.

Shilling says that lenders, who have made refinancing much simpler and less expensive than ever before, will change their tune as foreclosures continue to mount.

Last month, the number of US foreclosures in process hit 1.23 percent, the highest level in 30 years, according to the Mortgage Bankers Association.

Fannie Mae, the nation's largest home mortgage financer, has already announced a fee increase on cash-out refinance mortgages effective Feb. 1.

The hike can be as high as a half percent. On a $200,000 mortgage, that represents $1,000 a year in interest.

Fannie Mae cites credit risk for its move: Homeowners who tapped equity through cash-out refinancing default more frequently than other borrowers.

Other hurdles to refinancing have cropped up. As homeowners race to get the best interest rates, the time from application to closing has increased.

Just a couple of years ago the process could take as few as 10 days. Today it can take up to 60.

It may take still longer, experts say, as borrowers rush to close loans before the fees increase. A lot can happen in 60 days, and many borrowers are locking in interest rates. That can add cost: The longer the time you lock in, the more you pay.

For homeowners who do press ahead, experts say, the key to drawing real benefits from a cash-out refinancing is knowing how – and how not – to use the cash (see story, below left).

For Jennifer Whitworth, a cash-out refinance helped bring her debt situation under control. Ms. Whitworth, a single mother from Birmingham, Ala., was struggling to meet monthly mortgage, credit-card, and student-loan payments.

In June, she refinanced her mortgage, drawing $80,000 to cover what remained on her mortgage plus another $15,000 in cash.

"I paid off all my loans and credit cards," Whitworth says. "Now, I just have the one house payment. It just makes it easier to keep up with."

Along the way, her adjustable mortgage rate fell from 7.75 percent to 6.25 percent and her monthly mortgage payment fell.

She also extended the life of her loan from fewer than 12 years to 15 years. For Whitworth, the trade-off made sense.

But determining whether a cash-out refinance is a good move, experts agree, depends on your financial situation. Using home equity to pay off credit-card debt may sound like a good idea, but is it wise to take 30 years to pay off a debt you could have finished off in five or 10 years?

Not in most cases, says Ross Marino, a certified financial planner and president of the Cape Fear, N.C., chapter of the Financial Planning Association.

It is important to look at the overall interest you will pay, he says, and also factor in closing costs and fees.

Would-be refinancers may find that a home-equity line of credit will suffice – fees are lower, and payments need not be made over the life of your mortgage, says Marino.

He also warns that if you borrow more than 75 percent of your home's value, you may pay another quarter percent – and if you borrow 80 percent or more, you will have to pay for private mortgage insurance, which can add still another point.

Financial experts stress that homeowners should use caution before committing to cash-out refinancing.

People who are well into the life of their mortgage or who plan to move soon may find it financially disadvantageous.

In addition, cashing out will add to your total mortgage debt, and carries more costs than if you simply refinanced your remaining mortgage debt.

Still, those who do it can take advantage of today's low mortgage rates, and the interest on the first $100,000 is federally tax deductible regardless of how you use the cash. (Those who use the cash for home improvements, or in some cases, investments, have higher thresholds.)

But before going ahead with a cash-out refinance, ask yourself why you want the cash. Financial planners differ to some extent about how such cash should be used, but here are some general guidelines from the Financial Planners Association:

Debt reduction. Hands down, this is the No. 1 reason to refinance. Paying off credit cards charging 15 to 18 percent interest (which is not tax deductible) is a handsome return on your money. Borrowed from your 401(k)? Pay it off and get that money reinvested. Of course, paying off your credit cards doesn't do any good if you turn around and run up new debt.

Invest. This is a more controversial use of the money. On the one hand, because the effective interest rate (after tax deductions) you're paying on borrowed money is relatively low, it may not be too difficult to earn a higher after-tax return depending on the investments.

Some people have used the cash to invest in real estate or start a business, for example. But as the current bear market has painfully illustrated, investing involves risk – and this is your home on the line.

Spend. Economists credit cash-out refinancing as a major factor in propping up the nation's weak economy, but financial planners either discourage spending the money at all, or at least caution consumers about what they buy.

For example, remodeling that adds value to a home is often considered a sound purpose, as long as you're careful about what you remodel. Kitchens and bathrooms can recoup more of their costs in a home resale than a pool, for example.

Pulling out equity to pay for college is another popular reason to refinance. At least you are investing in something with a long-term financial payoff (for your child, anyway), but consider other college-financing alternatives first.

Most planners strongly discourage spending the money on purchases with short life spans, such as a new car or a dream vacation. Ask yourself: Do you really want to be paying for your trip to Tahiti for the next 15 or 30 years?