Be Careful About Cash-Out Refis

Posted by: Peter Coy on July 6, 2005

Taking out some cash when you refinance a fixed-rate mortgage seems like the closest thing there is to picking up free money.

But there’s a big, hidden cost in the future, according to a nicely done new article in a publication you probably don’t see every day, The Regional Economist, published by the Federal Reserve Bank of St. Louis.

The piece by senior economist William Emmons comes to this conclusion:

Unless a household really needs the extra cash today, cash-out refinancing may not be the best choice. Even though the monthly payment may remain the same, the increased mortgage principal amount represents a greater debt burden that must be repaid in the future.

You need to read the whole article to understand it, but the key idea is that falling interest rates (which borrowers like) are almost always accompanied by falling inflation (which borrowers don't like). Inflation is the debtor's friend. It makes the real cost of fixed mortgage payments shrink over time. So when inflation is lower, the real cost of the payments shrinks more slowly. That's bad for you.

So let's say interest rates--and inflation--fall. If you react by taking out a bigger loan and extracting cash, you're condemning yourself to carrying a high real debt burden for years to come. Higher than if you simply borrowed the same amount. And much higher than in the old world of higher interest rates and higher inflation.

There ain't no such thing as a free lunch.

 

About

BusinessWeek editors Chris Palmeri, Prashant Gopal and Peter Coy chronicle the highs and lows of the housing and mortgage markets on their Hot Property blog. In print and online, the Hot Property team first wrote about the potential downside of lenders pushing riskier, "option ARM" mortgages and the rise in mortgage fraud back in 2005—well ahead of many other media outlets. In 2008, Hot Property bloggers finished #1 in a ranking of the world's top 100 "most powerful property people" by the British real estate website Global edge. Hot Property was named among the 25 most influential real estate blogs of 2007 by Inman News.

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