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The Pitfalls of Cash-Out Refinancing in a Rising Interest Rate Environment

Cash-strapped borrowers 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.  With today’s higher mortgage interest rates, taking out these first-lien loans will damage borrowers’ long-term financial health.  Particularly concerning are 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.

In The Pitfalls of Cash-Out Refinancing in a Rising Interest Rate Environment, The American Enterprise Institute (AEI) Housing Center and the Center for Responsible Lending (CRL) analyzed public and proprietary data to assess the damage, to identify better alternatives, and to make recommendations to the FHA, the VA, and the government-sponsored enterprises (GSEs).

In a cash-out refinance, a homeowner with a mortgage takes out a new larger loan to pay off the outstand­ing principal on the existing mortgage and provide some amount of additional cash (the “cash out” in a cash-out refinance). Because the cash-out refinance interest rate is applied to that entire larger loan amount, cash-out refinances increase the amount of interest the homeowner pays on their existing loan balance whenever the cash-out refinance rate is above the original mortgage rate. In today’s environment, refinancing usually does mean taking on a higher interest rate—typically two to four percentage points above one’s existing rate.  For example, the median interest rate on outstanding FHA and VA loans is 3.2% and 90% of these loans have an interest rate below 4.63%, while the rate on a cash-out refinance in late 2022 was close to 6.5%.

As a result, the typical FHA or VA borrower who completed a cash-out refinance in November 2022, obtaining about $36,000 in cash, saw their monthly principal and interest payment (P&I) on the balance of their old mortgage increase by $368 (37%).  Assuming the borrower maintains the new mortgage for seven years, they will pay about $42,000 of additional interest on their existing loan balance – more than the amount of cash they obtained from the refinance.  In addition, the borrower also takes on higher monthly payments because the new mortgage will be for a larger amount than the prior mortgage.

We are particularly concerned that the FHA and VA share of cash-out refinances increased from 16% in January 2022 to 42% in January 2023.  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.  And even among FHA borrowers, cash-out refinance loans disproportionately are being taken out by lower credit score borrowers and borrowers in neighborhoods with higher shares of Black residents.  In addition, lower credit score homeowners constitute an increasing share of both FHA and VA cash-out refinance borrowers.

In the current interest rate environment, a second-lien home equity loan is a far better way to turn home equity into cash.  With a home equity loan, the borrower retains their original mortgage interest rate, and the interest rate for the home equity loan is applied only to the extracted equity.  With interest rates today considerably above most borrowers’ current mortgage rates, a borrower’s monthly P&I payment for their existing mortgage plus a home equity loan would be less than for a cash-out refinance.  Even at an assumed interest rate of 13% vs. 6.5% for the cash-out refinance, our typical FHA or VA cash-out refinance borrower would have ended up paying $38,000 less in total interest over the seven years following the equity extraction by maintaining their existing mortgage and taking out a $36,000 home equity loan instead.

Home equity loans also usually have a shorter stated term (typically 10 years) than cash-out refinances (usually 30 years).  Therefore, with a home equity loan, a larger share of the borrower’s monthly payments is applied to reducing the principal balance when compared to a cash-out refinance. This means that the borrower who adds a home equity loan on top of an existing mortgage will accumulate equity faster than the cash-out refinance borrower who substitutes a new 30-year loan for an existing loan with less than 30 years to go until scheduled repayment.

In addition, because closing costs are a percentage of the total loan amount, closing costs for our typical borrower are three to four times higher on a cash-out refinance than they would be on a home equity loan. These closing costs are typically folded into the new mortgage, further slowing home equity accumulation for the cash-out refinance borrower. As a result, our typical FHA or VA cash-out refinance borrower would have accumulated $42,000 more in equity over seven years if they had taken out a home equity loan instead of a cash-out refinance.

In the current higher interest rate environment, AEI Housing Center and CRL believe that lower-wealth, lower credit score, minority, and veteran homeowners should be offered better alternatives for prudently accessing their equity, such as tradi­tional second-lien home equity loans. And homeowners in need of liquidity should not have to risk their future financial security because they don’t have access to clear and reliable information about the financial consequences of cash-out refinances. Increasing the availability of home equity loans and providing protections from harmful refinancings would help ensure that homeowners’ current financial needs are met—and their future financial health is secure.

The following actions would help ensure that all borrowers, especially FHA and VA borrowers, have equity access options that do not require them to give up their valuable current lower-rate mortgages and incur both high closing costs and large, unnecessary hits to their home equity.

(1) Lenders should develop and make broadly available second mortgage products like home equity loans and HELOCs. Broader availability at market interest rates, including for lower credit score borrowers, will save consumers money and better steward their equity while expanding lines of business for financial institutions.

(2) The FHA, the VA, and the GSEs should conduct an immediate review of cash-out refinances, evaluate the risks to low-income and minority borrowers as noted above, and implement effective measures to discourage harmful refinancings.


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