he global economy saw its fall down after Covid 19, which began as a health pandemic but ultimately led to a worldwide economic crisis. The Covid 19 restrictions and precautionary measures jeopardized economic activities and thus, pushing the world into a recession. This caused a massive increase in unemployment in several countries, rising inflation, a rapid fall in economic growth, and the tourism and hospitality industry collapse. But fortunately, the Covid 19 recession was the shortest in the U.S., lasting for two months. However, the experts believe that the world is heading into a new recession.
It's always best to prepare for the recession as it can significantly impact your personal finances. The recession can bring you financial difficulties, and you need to prepare beforehand for it. Most people use houses as ATMs during these difficult times. When you are out of cash, it's advisable to use mortgage refinancing, home equity loans, or home equity lines of credit to pull cash out of your houses.
This gives you the emergency fund you would need to pull yourself out of that difficult financial situation. But, should you consider refinance cash out or home equity during a recession? Let's find out in detail.
Understanding Recession and Its Impact On The Housing Market
A recession is a significant decrease in economic activity over a period of time and is often characterized by negative economic growth. It is an economic situation where the overall household consumption and income level decrease and the unemployment rate increases. Usually, recessions are mild and last for a short period. But, it is not known when they will hit or how bad it will get. Each recession is different, and so is its impact on the economy.
The Great Recession 2008
The U.S. saw a great recession in 2008 that lasted from December 2007 to June 2009. It was the most prolonged and worst-hitting recession since the Great depression. The mortgage crisis caused the recession, which triggered the global bank credit crisis. In short, the banks were offering subprime mortgages, which are given to high-risk borrowers with low credit scores. This increased the demand for houses, thus skyrocketing the house prices.
The people took advantage of the high house prices by refinancing their house equity. But, when they could not pay the mortgage, the banks auctioned the houses. With the increasing number of auctioned homes, house prices dropped significantly. With the drop in house prices, homeowners lost their equity value and were indebted to the loan they could not pay. This led the financial institution to file for bankruptcy, causing the global economic crisis.
The 2020 Recession
The Covid pandemic caused a recession in 2020, but this seems to be much different from the 2008 recession. First thing, the recession was not caused by the financial sector but due to the pandemic. Secondly, the recession lasted for two months only. Though the 2020 recession initially began as a health concern, the Covid restrictions jeopardized the entire financial activity, including real estate. People were more concerned about their health and were busy managing the necessities than looking for a new house.
But the aftermath of the Covid significantly impacted the housing market. The most essential asset during the pandemic was a house. For most busy people, for whom the house was just a place to eat and sleep, it had become the office and school. Thus, people wanted to upgrade their current housing. This led to the booming of the housing market and the housing prices reaching their peak.
Why House Is The Source Of Fund During Financial Hardships?
For many Americans, buying a house is a secure and long-term investment. It is a valuable asset to which they can cash out during the financial hard times. For instance, if you have to pay your medical debt, you can put your house on loan to cash out money to pay your medical bills.
During recessions, there are high unemployment rates and low incomes and profits. If you lose your job or your income is temporarily distressed such that you cannot meet your financial needs, you can choose to cash out your home's equity.
Equity is your ownership of the home, which is the difference between the value of your home and the mortgage you own. Most Americans have their equity trapped in their home, which can be used for several other reasons. This equity can be used as collateral to take out loans. There are several ways in which you can release your equity from home. The most popular ones are cash-out refinancing and Home equity loans.
Should You Consider Refinance Cash Out or Home Equity During a Recession?
Refinance Cash Out
Refinance cash out usually replaces the current loan with bigger loans, enabling you to use the equity in your house and get the difference between your existing mortgage and the new mortgage in cash.
For instance, your house was valued at $1 M, and you took out the mortgage of $800k. You have paid the mortgage over the years, and now you have a $600K mortgage and $400 K equity. You can also take out a loan from the equity that you have accumulated. You can borrow 80 % of your equity. In this case, you can borrow 320 K. Now, your total loan would be 920 K, and you can cash out 320 K.
Pros Of Refinancing Cash Out In Recession
- You can get lower mortgage interest rates and save up the interest amount.
- You can consolidate your debts by replacing high-interest debt with a lower interest rate.
- Your mortgage interest may be tax-deductible.
Cons Of Refinancing Cash Out In Recession
- It will increase your financial baggage in uncertain times.
- Cash-out refinancing is like getting a new loan. If your house value has dropped or your income is temporarily distressed, there is a high chance that your loan application will be rejected.
- The lender restricts the lending process by increasing the minimum credit scores and criteria for the loan application during the recession. So, it is harder to cash out refinance during a recession than in a stable economy.
Home Equity Loans
If you want to refinance your home, you can take out a new loan instead to use your trapped equity. In-home equity loans, you are taking a second mortgage out of the home equity trapped in your home. The amount of a home equity loan is determined by the difference between the house's current market value and the existing mortgage debt.
For instance, the current value of your home is $1 M, and you have a $500 K existing mortgage. You own $500 K equity in the house. The lender allows you to borrow 80 % of your home value, which is $800 K, and now you have a $500 K mortgage. This means you can borrow a $300k home equity loan.
Pros Of Home Equity Loans In Recession
- The mortgage interest rate is at an all-time low, and you can take advantage of the lower interest rate.
- Home equity loans typically have fixed interest rates, so you are locking the lower interest rates.
Cons Of Home Equity Loans In Recession
- You are adding financial baggage to your existing loan. Now, you have two loans on the same property, and if you cannot pay back the loan, you may lose your house and even your personal belongings.
- The value of your home decreases in a recession, which might lower your home's equity. So, you are getting less than what you could have in normal times.
While most economic activity declines during the recession, it might not seem like the best time to refinance your home. But, with proper rate shopping and research, a recession can be the best time to consider refinancing your mortgage due to the low mortgage interest rate.
If you can lock the low-interest rate during the recession, you will reduce your financial baggage, which you can later pay off when things get normal. While there is no hard and fast rule on which option is preferable. It depends on your financial requirements and needs. Thus, make sure you analyze the pros and cons of each option and choose the best option for you.