Refinancing to cash out equity can lead to foreclosure

In previous posts I discussed how lenders were eager to originate more loans. These were not just for first time buyers getting into the market, many existing homeowners were enticed into taking out equity.

About 28% of the recent foreclosures in Bergen County seem to be a result of people cashing out their equity. Of the 135 homes that the foreclosure process was initiated that had judgments against them in excess of the average purchase price, the average price was $324,838 but the average judgment is $486,531. That's almost 50% more than what they paid for the house.

The chart below shows the number of these foreclosures grouped by the year in which they were purchased. The red line is the number of homes that were purchased in that year and the blue line shows the average difference between the judgment and the purchase price for the homes purchased that year.

What is disturbing is that of these 28% of recent foreclosures, not only do the borrowers need to worry that the property values are less than what they paid, they borrowed more than they actually paid! Lenders seemed to be willing to give out more than the purchase price, probably based on future inflated pricing that hasn't been realized? Don't be persuaded to think that the practice tapered off as much as the graph indicates. Since the Bergen County Clerk doesn't provide mortgage information online, like other NJ counties do, I had to go by foreclosure data. Since it takes time for the foreclosure process to even begin, the data is usually a few months delayed.

Just picture it, you struggled for years to build up a good sized down payment, you spent months searching for the right home for your family that was priced in a range you could qualify for and you have been slowly building equity in the property. But that hasn't been your main concern. While you did expect that your house would increase in value and that your fixed rate traditional loan over time would pay down your principal, your primary motivation was to have a nice home, with a good school system for your children. Then one day you look around and see what's going on. People were pulling money hand over fist out of the real estate market.

House prices are soaring and you're wondering "how can these people afford these houses". You start trying to figure out how much they are making, because you have a pretty good paying job and it took you a long time to save up and buy a house. Pretty soon you realize they're not making more money, they're just able to borrow more money. And it has nothing to do with their income or their credit in many cases. For some, they've cashed out equity at the time they were getting their first mortgage. In some cases they were able to borrow more than they property was currently worth.

You look at your situation and think, I'm in good shape, I have a good job, I already found the home I want, at a good price and after a few short years I'm sitting on more equity than I know what to do with. I want what some of these people are getting. You look at interest rates and say "well, I'd actually save money with a lower rate". Maybe you decide not to go too crazy but you're talking to loan officers and they're trying to get you to see your house as a cash machine.

Maybe that wasn't the case. Maybe you lost your job and needed money, there might have been an illness in the family that drained your resources or it was college time for the kids and you hadn't saved enough. There were so many reasons people decided to cash out equity. Some were unavoidable. Life has hiccups that can derail the best laid plans. But what's been happening is more than just that.

To take out equity in your home, you could either refinance your existing mortgage for an amount greater than what you currently owed to your first mortgage and pocket the difference, or take out a equity line of credit against the equity in the home. And loan officers would have no problem giving these to anyone. No income? No problem! Many lenders were willing to give you a loan without verifying income, just based on the equity in the home.

The problem with refinancing to cash out equity, or taking out a equity line of credit is that you were borrowing against equity that was about to come crashing down. The home prices were artificially inflated due to the amount of credit that was thrown out into the market. With more people able to get loans, home ownership was rising and people were buying houses like there was no tomorrow. Even though our government was concerned about artificially inflated house prices as early as 2001, borrowers and lenders kept on going as if the rapid increase in values was natural and going to continue indefinitely.

Pretty soon, the problems with giving out so many non prime loans started to show up. People were unable to keep up their payments and foreclosures started to rise. The lenders threw out more loans to try and keep house prices afloat but there's only so much that can be done. Eventually values started dropping.

Taking out equity through refinancing or a HELOC, isn't always a bad idea. If you can afford the payments and put the money to good use, it's something you need to do sometimes. But if you tried to take out equity, to get into the real estate market too late in the game, you might end up with two properties in foreclosure. For at least two people facing foreclosure on two properties each that seems to be the case. One purchased a home in 2002 for just over $200k which isn't too bad. The judgment though is over $400k. In 2006 they purchased another home for around $450k which also has a $400k judgment against it. 

Another buyer that purchased a home for around $170k in 2000, has a judgment against that home in excess of $500k as well as another home purchased in 2006 for $750k that has a $500k judgment as well.

Other things might have happened but it seems these people didn't use the equity in their homes wisely or got caught up in the hype at the tail end of the bubble.

If you took out a HELOC and started a side business and your monthly returns were greater than your payments you were in great shape. If you were able to purchase property at reasonable rates that you could rent out to cover your mortgages, you'd be fine too. But with the inflated prices those types of properties were hard to find.

If you need to take equity out of your home, learn from what's happened recently. Really think if you can afford to make the payments. Consider the type of loan you are getting and if the payments will stay the same. Don't take out equity unless you really need it. Your house isn't a credit card to purchase expensive cars, flat screen tv's etc. When people try to get you to take out a loan, remember, they make money when you do, so always look for other opinions and options as well.