Using Your Home as an ATM

A: As the national housing market continues to correct and NYC continues to remain healthy, the question of equity withdrawal becomes a key one as the value of one's home (especially outside of NYC) may not be as high as it used to be. Cashing out equity in your home is something that I always wanted to discuss here on UrbanDigs, because a lot of the times it is done for all the wrong reasons, and worth a brief discussion.

Cashing out equity in your home or re-financing in today's interest rate environment, is something that should be done only if absolutely necessary. It really doesn't make sense to re-finance today unless your short term ARM is expiring, but even that might not make sense as there is a cap to how much the expired ARM rate can rise at each adjustment. If you locked in a much lower rate 3 years ago, chances are today's rate will be higher than the adjusted rate of the expired ARM, at least for now.

Re-financing is a wise financing decision in a rate easing environment where homeowners have a chance to lock in a lower rate than what they originally got for their loan. Not so in today's market as rates have been rising for 3 years now.

If you are thinking about cashing out equity from your home, via a HELOC (which is a variable rate loan and sensitive to future rate increases, so be very careful!), ask yourself 'why are you doing it' first. Every re-finance or equity cash out comes with a transaction fee that must be analyzed to see if it is worthwhile.

For re-financing, the general rule of thumb is:

IF OVER THE COURSE OF 12 MONTHS THE SAVINGS DUE TO THE LOWER RATE IS MORE THAN THE TRANSACTION FEES, THAN IT IS WORTHWHILE. IF NOT, THEN IT DOESN'T MAKE MUCH SENSE.

For example, if it costs you $2,250 to re-finance your loan to a lower rate (which is obviously hypothetical unless you locked in your rate 6-7 years ago) but you are now saving $200 a month due to the lower rate, than that adds up to $2,400 a year in savings, making this transaction worthwhile. If you were ONLY saving $100 a month due to the lower rate, than you will only be saving $1,200 a year and the transaction costs would be too high to make this deal worthwhile.

Now on to cashing out equity! Why do you need the money? This country has an obsession with debt, as most people's spending habits far outweigh their discipline for financially viable decisions. Here is a breakdown of what I consider good vs bad reasons to cash out equity in your home, which will lead to a 2nd mortgage payment usually with a variable rate product (the worst lending product to take out in a rising interest rate environment).

BAD REASONS TO CASH OUT EQUITY

1. To Be Able To Afford Your Monthly Payments - If you are in a position whereby you have to cash out $30K, or $40K, or more to be able to comfortably afford the expenses of living in your home, than you bought too much home to begin with and should strongly consider selling it! Cashing out equity to simply have a larger amount of liquid assets is a horrible decision for anyone seeking to live a independent financial lifestyle. Trust me, what will happen is that you will go through that money faster than you think and in the end you will be left with higher monthly expenses than you started with and be in a position where now you might be forced to sell; the worst type of seller whose only weapon is to lower their asking drastically to move the property fast.

2. To pay off credit card debt - This is a tough call. In general its never a good idea to pay off short term debt with long term debt. I consider credit debt short term debt (actually one of the worst kinds of debt that is out there) and cashing out equity to pay off high interest credit debt is only a SHORT TERM FIX. If you have credit debt problems than you have a more serious underlying problem with shopping/spending. That is something that doesn't go away easily and is more tied to your own behavior and coping systems. By doing this, you will almost certainly start spending again now that you have clear credit cards with nothing but max credit available to you, and over time, you will max out again only this time you have went through equity in your home and increased your monthly living expenses at the same time. A recipe for disaster.

3. To pay for a big event/vacation - Another hard one for me to discuss but if you are considering cashing out $25K in equity to pay for a wedding, or a luxury 2 week vacation for twice a year, or a huge party that you want to throw for your family, DON'T! Stop thinking about making your wife or your parents or your friends happy and start thinking about your financial well-being. If you can't afford a big event or vacation now, than WAIT, and save up for it. You'll feel better about it in the end, you'll enjoy it more with the satisfaction that you saved up for it, and you'll own more equity in your home when you go to resell!

GOOD REASONS TO CASH OUT EQUITY

1. Renovations - Out of most reasons people use money that they cashed out of their home, renovations seems to me to be one of the most viable financial decisions. Generally speaking, renovations in NYC property's, especially in kitchens, baths and floors, get back most if not more of the overall expense at resale. So, why not do it earlier giving you time to enjoy the new work. Just be sure that your job is secure and that your salary can afford the higher monthly living expenses that will come from the cash out. But overall, using some equity to increase the value of your property's home is not such a bad idea.

2. If you plan to sell, but need some cash to satisfy the tax code - Interesting thought on this one. This ONLY applies to those homeowners who intend to sell, but are a little light on liquid assets and need some cushion to afford them time on the market and to satisfy the primary residence tax benefits code. As I discussed before, you need to satisfy the 2YRS ownership and use test to be able to NOT pay Capital gains taxes on up to $250K in profit for singles and up to $500K in profit for married couples. Since you are saving the money by not paying taxes on the gain, you can make an argument that cashing out $20K or so of equity to possibly save up to $40-50K in taxes on capital gains, makes sense. This only applies to those with this specific plan and who have committed to selling their property once they meet the tax requirements.

If you want to get more serious about how MEW (mortgage equity withdrawal) is changing as the housing market cools across the nation, than be sure to read Calculated Risk's entry on the topic:

MEW's Impact on 2007

Originally Published July 10th, 2006

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