In the early 2000s, property values were rising at a rapid rate and bringing with it newfound home equity. As property values rose and mortgage rates dropped, the temptation to refinance and take cash out became irresistible for many. This financial transaction is not so affectionately known as “using your home as an ATM.” It's officially known as a cash out refinance.
This is not to say that everyone who cashed in on their home equity used the money frivolously. Many used these funds to pay medical bills or education expenses as a last resort. Regardless, refinancing to take out cash can be a very risky proposition. Some of those who did a cash out refinance are still underwater or worse, lost there homes.
Real Estate Market – A Brief History
Many real estate professionals consider the summer of 2006 to have been the peak in home prices during that period. This is when the real estate bubble started to burst. When you think about it, it wasn't so much a burst as it was a slowly deflating balloon. Rather than having prices crash over night, it took several years for the real estate market to bottom.
What soon followed was a recession so severe that it has become known as “The Great Recession” and a near total collapse of our financial system as we know it. This economic period was so bad that it rivals The Great Depression of the 1930s. Some economic and financial experts believe we were only one more bank failure away from a depression even more severe than The Great Depression.
We often think of this period as a real estate bubble where prices were over inflated. It many ways, it was. However, it was really more of a debt bubble. We simply took on too much debt. Everyone. Consumers, investors, bankers, and governments all played a part in the debt bubble and the serious economic impact that followed.
Home Equity – Today
We are 12 years past when the bubble began to burst. Some homeowners are still underwater. Others are coming up for air. If you bought a home in the last seven or eight years, you probably have equity in your home. Property values have been rising and interest rates are low. Sound familiar?
According to real estate website Zillow, home values in the Sacramento region were around $193,000 in July of 2013. Five years later, home values in the same region are around $316,000. If you put 10% down on a $193,000 home in July of 2013, you probably have about $160,000 in equity! For many, this is like cash burning a hole in your pocket and with rates still historically low, many can't resist tapping into their equity.
Recent studies indicate home owners are reluctant to tap into their home equity. According to data provider Black Night Inc. via this LA Times article, Americans have more than $5.8 trillion in equity and aren't tapping into it. This is a great sign that we may be learning from our past mistakes.
However, the further the carnage of the last decade's real estate debacle goes into the rear view mirror, the more likely we are to wade back into dangerous waters. According to the article above, banks are ramping up the marketing machine and encouraging home owners to tap into their home equity again. Proceed with caution.
Lessons learned about home equity and the bursting of the housing bubble:
1. Our homes should not be used as ATM machines: Use credit and debt prudently. A home can be a great way to help build wealth over the long term, but only if you can keep your home. If you keep refinancing to take cash out or running up a home equity line of credit, you put yourself at risk.
I know many people who relied on rising home values to fund there lifestyle. Every time they could tap into their home equity they did. The process continued because home values kept rising. As long as they had jobs and could afford the payment, there wasn't an issue. That is until someone is laid off or the interest rate increases on an adjustable rate loan.
2. Too much debt is a BAD thing: There are some people who believe debt is bad. I don't subscribe to that belief. If you can use credit and debt prudently it can help you increase income and build wealth. What is bad it too much debt. What is too much debt? That number might be different for a lot of people. For me, too much debt is what puts you at risk of losing an asset (your home) due to a reduction in your income or increase in payments.
3. Home values CAN go down: One of the fallacies that contributed to the housing crash and The Great Recession was that home prices never go down. We all know that nothing could be further from the truth. Don't assume that recent gains in property values and the corresponding improvements in home equity will continue indefinitely. Think of your home equity as a buffer against potential home value losses in the future.
While some may be prone to making the same mistake again, others may be at risk of going too far the other direction. Due to past mistakes and bad experiences with debt, some borrowers get overly ambitious when it comes to paying down their mortgage debt. I recently encountered a person who was considering withdrawing early from their 401k to pay off a loan.
I can appreciate the desire to pay off debt. However, the rush to do so can result in paying significant taxes and not getting as much bang for your buck. This is compounded by the loss of potential future earnings on those funds.
Paying the 10% penalty for early withdrawal from the 401k is on top of ordinary income taxes that would be due. Look at whatever you withdraw from a 401k (assuming all dollars are pre-tax) as regular income. The 10% penalty adds insult to injury.
The worst place to take funds to pay off debt is from tax deferred accounts like 401k and IRA. This is especially the case if you are under 50 due to the penalties involved.
Now that home values are rising, let's not blow it this time. Resist the urge to cash in on your equity. When you take out a loan or mortgage on your home, the goal is to pay it off not add to your debt. We'll all be much better off in the long run if we prudently manage our debt and consistently save for our future.
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