Why Cash-Out Refinancings Aren’t Raising Alarm Bells This Time

After the housing finance crisis of 2007, a great deal of industry hand-wringing took place. Unscrupulous subprime lenders got much of the blame; so did (now defunct) lenders who made cash-out refinance loans.

Cash-out refinances increased from 21 percent of total loan production in 2001 to 46 percent by third quarter 2015, and they performed worse and had greater losses than purchase loans and rate refinances, even when controlling for credit characteristics, according to the Urban Institute, Washington, D.C.

Lenders reacted to the crisis by imposing rigorous underwriting standards. What followed, analysts agree, was a period that featured the best quality mortgage loans in the history of housing. But amid complaints that lenders had swung the pendulum too far–and in doing so, cutting off access to thousands of otherwise creditworthy borrowers–the lending industry has slowly begun to relax standards again.

And with that relaxation has come the return of several products that many critics say precipitated the 2007 crisis, such as subprime loans and cash-out refinances. But a recent paper UI paper (https://www.urban.org/urban-wire/cash-out-refinancing-rise-again-heres-why-we-arent-worried) notes while cash-outs are on the rise, there is less to worry about this time around.

UI said based on Freddie Mac data, the share of refinance loans where borrowers increase their loan balance to extract equity from their home has reached the highest point since 2008 and stood at 77 percent of total refinances in the second quarter. But the volume of home equity cashed out remains below crisis peaks: home equity cashed out through the conventional channel in the second quarter totaled $15.8 billion, far below the “dangerous highs” between $75 and $85 billion in the pre-crisis years.

“Moreover, the growing share of cash-out refinances is expected when you consider the current fundamentals of the mortgage market,” said authors Laurie Goodman, Edward Golding and Sarah Strochak.

UI identified three reasons why the growing share is no reason for concern.

–The cash-out refinance share is strongly correlated with home price appreciation and rising interest rates. “The current environment–rising interest rates and strong home price appreciation–is driving the higher cash-out refinance share,” UI said. “Home price appreciation has been robust over the past few years, averaging between 6 and 8 percent. When homes are increasing in value, borrowers have an incentive to refinance their loans and tap into their mounting equity…Most borrowers cannot refinance their loans at a lower interest rate, meaning the predominant reason to refinance is to extract home equity.”

–The cash-out refinance share of total production is in line with historical trends. “When we look at the cash-out refinance share of all loans back to 1994, we find that today’s share is at or below other periods of rising interest rates and strong home price appreciation,” UI said. “Freddie Mac data indicate that some cash-out refinance activity is actually debt consolidation.”

–Borrowers are extracting less equity than they did during the financial crisis. “Today, cash-out dollars as a share of all refinanced originations is 21 percent and has averaged just below 8 percent since the crisis,” UI said. “Part of this reflects the fact that Fannie Mae, Freddie Mac, and the Federal Housing Administration have lowered the maximum loan-to-value ratio for cash-out refinances, reducing the amount of cash that can be extracted.”

UI noted while cash-outs make up the highest share of refinances they have since 2008, “this is no reason for alarm. In an environment of home price appreciation, people commonly tap into their home equity. Cash-out refinances allow homeowners to make home improvements, pay for educational and health care expenses, or maybe even buy the boat they’ve always wanted. Of course, prudent underwriting of the risks is always important, and current numbers indicate that cash-out underwriting is being done prudently.”