With home values soaring and mortgage rates still near historic lows, homeowners are cashing out equity at volumes not seen since the height of the housing bubble. Although alarm bells aren’t yet ringing, analysts are keeping a close eye on the trend.
That’s because if home prices reverse course, homeowners who pulled much of the equity out of their home when refinancing are at a higher risk of default.
A 2018 Urban Institute study of loans taken out between 1999 and 2016 found that cash-out refis had a 97 percent higher probability of defaulting than purchase loans. The default rate on cash-out refis approved in 2007 was 17.1 percent, compared to 9.6 percent for purchase loans.
The study concluded that the main cause of the 2007-09 financial crisis and the recession that followed might not have been lending to marginal borrowers.
Instead, “The poor performance of the cash-out refinances and refinances more generally, are more important contributing factors.”
More recently, a monthly chartbook published by the Urban Institute’s Housing Finance Policy Center last month shows homeowners refinancing conventional mortgages pulled nearly $50 billion in equity out of their homes in the last three months of 2020.
“Leading up to the global financial crisis, cash-out refinance mortgage loans were a significant driver of risk as many borrowers extracted equity from growing home prices,” said Jonathan Glowacki, a principal at global consulting and actuarial firm, Milliman. “While cash-out refinance volume has increased significantly in 2020 and 2021, we believe the risk is now somewhat mitigated by tighter underwriting standards, namely capped LTV ratios.”
Glowacki is the author of the Milliman Mortgage Default Index (MMDI), which estimates the lifetime default risk of government-backed mortgages. The latest Milliman MMDI report notes that while loan-to-value ratios on most cash-out refis can’t exceed 80 percent, there’s been an increased use of automated appraisals during the pandemic.
“With little inventory, it is possible the models used for appraisal waivers are biased and do not reflect a steady-state housing market,” Glowacki wrote. But that risk is mitigated by the fact that LTVs on cash-out refis are capped at 70 percent if an automated appraisal is used.
“Milliman will continue to monitor the performance and volume of cash-out refinance loans. Currently, these mortgages do not appear to present a significant risk to the mortgage market,” the report concludes.
Another potentially mitigating factor is that credit scores on both purchase loans and refis hit all-time highs in 2020. But according to Black Knight’s latest mortgage monitor, lenders have relaxed their standards, and credits scores have begun to sag this year.
For borrowers approved for “rate and term” refinances that don’t involve taking cash out, average credit scores are down 13 points so far this year. The average credit score for borrowers approved for cash-out refinancing hasn’t fallen as much — it’s down eight points, Black Knight reports.
With home prices continuing to appreciate and the economy mending from the pandemic, there are few signs of a looming foreclosure crisis. Even though nearly 2 million homeowners are three months or more behind on their mortgage payments, many homeowners who entered into forbearance early in the pandemic are now resuming payments paying their mortgages off.