Tips on tapping into home's equity through refinancing

Ellen James Martin

Published: June 14, 2008

Until a few years ago, it was an extremely common practice among homeowners to pull money out of their property through a "cash out” mortgage refinance.

People used the funds for a huge array of purposes, from buying boats to taking lavish vacations in Hawaii.

But the practice of bankrolling one's dreams by tapping home equity has slowed dramatically. One obvious reason is that there's less equity to tap — given that property values have slipped in a number of neighborhoods.

Another factor is that a tougher economy has served as a "wake-up call” for many consumers, said Eric Tyson, a personal finance expert and co-author of "Mortgages for Dummies.”

"Many who used their houses like ATM machines now regret their behavior, especially if they took money out for frivolous purchases, like luxury trips or buying fancy living room furniture,” Tyson said.

Even so, as he points out, there are still many homeowners with plenty of remaining equity — people who could easily convince a lender to give them a cash-out refinance loan. In addition, there are others who own their properties free and clear — meaning they now owe nothing to a lender. To get equity out, they could simply re-mortgage their property.

But in this time of economic upheaval, is it prudent to look to your home as a source of cash? The answer depends on your overall financial picture and your plans for use of the money, according to Tyson.

"Home equity should never be used for ordinary consumption — like food and gas costs. If you need to borrow for your basic lifestyle, you're living beyond your means. Nor should home equity go for extravagances, like a designer handbag priced at over $1,000. But some uses could be legit — like funding your child's college education,” Tyson said.

Here are several pointers for those considering mortgage refinance to take cash out of their home:

The traditional way of judging the market value of a property is to hire an appraiser. This costs several hundred dollars and yields a mathematical analysis of your home's worth based on recently closed sales that involved similar, nearby properties.

One less-expensive and potentially more up-to-date way to get an estimate of value is through a seasoned real estate agent who has sold properties in your neighborhood for many years, said Dorcas Helfant, a former president of the National Association of Realtors.

"Realtors who've worked in your neck of the woods for a long while should know local properties in and out. In a changing market like this one, they have their finger on the pulse of local valuation trends,” Helfant said.

If you're contemplating refinance and are unsure how much equity you have, Helfant said you should feel free to ask local real estate agents for their views on the subject.

To come up with a rough calculation of your equity, take the agent's figure on the value of your property and subtract the balance currently owed to your mortgage lender. This should give you an estimate of your equity position and whether a cash-out refinance is a plausible idea.

Many people considering a cash-out refinance view this as an isolated decision and fail to consider their overall financial picture before taking the step, Tyson said.

"This is the wrong approach. You've got to do some serious number crunching before you go to your lender's office to tap your equity,” he says.

Whether you can afford to do a cash-out refinance depends heavily on how well you've been investing toward your long-range money goals, including retirement, Tyson said. Doing an assessment of your progress is especially important for those who've already reached middle-age or beyond.

A trusted financial planner or accountant could help you decide if you should preserve all the remaining equity in your home to help you retire comfortably. Another way to evaluate your progress is to use one of the free retirement income calculators available through the Web sites of major mutual fund companies, such as T. Rowe Price ( www.troweprice.com) and Vanguard ( www.vanguard.com).

Until recently, a large proportion of new car purchases have been made from funds taken through a cash-out refinance or through the use of a home equity line. But Tyson is skeptical of this use of home equity.

"If you can avoid it, never touch the savings in your house to buy a car, which is an asset sure to depreciate in value,” he said.

In Tyson's view, there are several other uses for home equity that could be more justifiable than for a car purchase. For instance, those who've already stashed away enough money for retirement may wish to do a "cash out” refinance for the down payment on a second home where they expect to move one day.

Another potentially reasonable use of home equity is to underwrite the cost of a college education for one or more of your children — though Tyson said you should resort to this only after searching first for alternative sources of funding, such as scholarships and low-cost student loans.

"Education is truly an investment in your children's future. It's not an asset that will definitely depreciate over time, like a car or a sofa,” Tyson said.

Paying off credit card debt through a cash-out mortgage refinance sounds like a sensible plan for those struggling with high payments on their plastic. After all, most mortgage loans carry much lower interest rates than do credit cards. Another advantage is that mortgage interest is tax-deductible, unlike credit card interest.

Though it sounds rational, Tyson said this plan could be an invitation to greater financial troubles for those who don't make fundamental changes in their spending patterns.

"Many people who use home equity to get out of credit card debt simply revert to the same bad habits. They pay off their cards and then run up their balances for a second, third or fourth time,” he said.

"A person with a history of poor money management had better face up to their weaknesses. Once you've paid off those credit card balances, you've got to cut up all your cards and refuse new ones. Otherwise you could be headed for financial ruin,” Tyson said.

To contact Ellen James Martin, e-mail her at ellenjames martin@gmail.com.

Universal Press Syndicate

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