When your home value climbs, your net worth climbs. But more than that, you feel richer. And when you feel richer, you’re statistically more likely to borrow against your home equity.
It turns out, this relationship between home price fluctuations and equity extraction is cozier than some had thought.
"Household spending has closely tracked house prices in Canada,” Bank of Canada researchers noted today. "As home values rise, homeowners find it easier to borrow using their home value as security."
Homeowners can extract equity in one of two ways: via a HELOC or a traditional mortgage refinance.
The first, and more popular way, is the Home Equity Line of Credit (HELOC). Most lenders allow homeowners to borrow up to 65% of the value of their home in a revolving HELOC.
In 2018, two million homeowners tapped into $49 billion worth of home value by way of HELOCs. Comparatively, just 380,000 households refinanced using a mortgage, accessing $40 billion.
"People who refinance their mortgage…tend to take out more equity than those who use HELOCs,” the BoC researchers noted. In 2017, the median amount of equity extracted through refinancing was $54,000 vs. just $12,000 for those taking equity through HELOCs.
All this cash being taken out of people’s home equity begs one big question. What’s it all being spent on?
Not surprisingly, the majority (28%) of refi funds go towards debt consolidation. For people forking out 20-29% interest on credit card debt, for example, consolidation is a life saver. By rolling $25,000 of 20% interest debt into a 2.99% mortgage, total interest expense drops from $11,795 to just $1,611, assuming you make a minimum 3% payment.
Other home equity uses:
Increased equity take-out isn’t necessarily a bad thing, according to the study.
“Equity extraction is economically important in Canada,” BoC staffers wrote. “In particular, we find that increased equity extraction has likely contributed materially to consumption and renovation spending in recent years.”
At the peak in 2017, they found that additional equity extraction added upwards of 11% to the level of spending on renovations, and about 2% to the level of consumer spending on durables and semi-durables. That contributed about 0.5% (which is a lot) to Canada’s Gross Domestic Product (GDP). That supported a multitude of Canadian jobs. In some places, like Alberta during the last oil price shock, researchers found that equity take-outs buffered the impact enough to avoid a bigger economic crisis.
Recent restrictions on refinancing, while seemingly prudent in the minds of policy-makers, could cause potential grief if the economy sours. “…If equity extraction contributes meaningfully to household spending in normal times, its absence can exacerbate spending cuts in bad times." BoC economists say that “could leave the economy more vulnerable…”
The stress test, which significantly limited the amount refinancers can qualify for, will definitely make the next economic downturn more interesting. If home prices dive, so too will loan amounts—since refinances are generally capped at 80% of a property’s value. Add in lower effective debt-ratio limits, thanks to the stricter government stress test, and many Canadians could find that their “home ATM” doesn’t spit out cash anymore.
How much will these “pro-cyclical” effects exacerbate the next recession? We’ll have to wait and see.