The American Enterprise Institute (AEI) Housing Center and the Center for Responsible Lending (CRL) have jointly prepared this brief. 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.
Our research leads to the following conclusions:
- 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).
- 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 cashout 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. 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.
- Lenders should make second mortgage products like home equity loans and home equity lines of credit (HELOCS) more available. Low-wealth, lower credit score, minority, and veteran borrowers served by the FHA and VA need better alternatives for accessing their equity in a higher interest rate environment, such as traditional home equity loans. In addition, the FHA, the VA, and the government-sponsored enterprises (GSEs) should conduct an immediate review of their cash-out refinancings and implement effective measures to discourage harmful refinancings.