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This article appears in the following Oxford Review of Economic Policy issue: HOUSING MARKETS AND THE ECONOMY [View the issue table of contents]
Sources and uses of equity extracted from homes
* Greenspan Associates LLC
** Federal Reserve Board, e-mail: jkennedy{at}frb.gov
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Abstract |
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In this paper, we present estimates of the disposition of the free cash generated by home equity extraction to finance consumer spending, outlays for home improvements, debt repayment, acquisition of assets, and other uses. We estimate free cash as cash available net of closing costs and repayment of other mortgage debt. We have also extended the quarterly data series for gross equity extraction, presented in our earlier paper (Greenspan and Kennedy, 2005), back to 1968.
Key Words: Mortgage equity withdrawal • wealth effect • consumer spending • savings rate
The views presented are solely those of the authors and do not represent those of the Federal Reserve Board or its staff. Nellie Liang, John Muellbauer, Michael Palumbo, Thomas Tallarini, and David Wilcox read the paper and provided a number of suggestions.
1 Others, most notably the Bank of England, also net out household investment in housing in their definition of home equity extraction (or mortgage equity withdrawal). Our preference is to present a measure of gross extraction that does not net out residential expenditures. As discussed below, this allows us to estimate separately the portion of gross equity extraction that is reinvested in housing, through either home purchases or outlays for improvements.
2 Greenspan and Kennedy (2005). Total gross equity extraction differs from the sum of the three types of equity extraction by a statistical discrepancy.
3 The remaining fifth includes mortgages to finance the purchase of new homes.
4 Because the personal saving rate is measured relative to personal disposable income, purchases financed with the proceeds of capital gains result in an increase in expenditures, but not income, which lowers the measured saving rate. The reason for excluding capital gains from income, and hence saving, is that only book saving can finance capital investment, a key requirement of the structure of our national accounts; in addition, capital gains do not add to gross domestic product (GDP).
5 Direct evidence on this point is limited. Manchester and Poterba (1989) addressed this question in their study of the explosion in home equity lending in the mid-1980s. They found that increased access to second mortgages reduced personal saving; that is, a major portion of the spending financed by home equity loans apparently would not have occurred otherwise.
6 Poterba (2000) includes a detailed review of the literature.
7 Among other studies, Elliot (1980) and Levin (1998) both concluded that financial wealth significantly influences PCE, but that non-financial wealth (including residential real estate) does not. Miles (1994), in a study on time-series data from the UK, reported an MPC from equity withdrawn from homes of 0.75. He argued that credit liberalization in the UK in the 1980s substantially boosted equity withdrawal. Based on panel data from the USA, Skinner (1993) found a small but significant effect from housing wealth to PCE. Case (1992) found that the real-estate boom in New England in the late 1980s significantly boosted consumption. The analysis leading to the specification of the PCE equation embedded in the Federal Reserve Board's FRB/US model of the US economy did not find a significant difference in the marginal propensity to consume (MPC) out of housing and stock-market wealth. The model explains most of the decline in the personal saving rate since the late-1990s by the rise in overall household net worth, without distinguishing between stock-market and housing wealth.
8 As discussed below, our measure of gross equity extraction includes all equity extracted from homes, including that which is reinvested in housing, through either a home purchase or improvement.
9 Specifically, repayments of home equity loans that occur when people sell their homes or refinance first liens.
10 We judgementally incorporated an upward revision to the shares of closed-end loans and HELOCs used for ‘real estate and business expenses’ in order to account for the increasing use in recent years of second liens used to finance home purchases. See the Appendix for more details. Note that if we were to use instead the shares from the CBA or the ABA, we would show larger amounts of the proceeds from home equity loans going to PCE and smaller shares going to the repayment of non-mortgage debt.
11 Readers may request a spreadsheet with quarterly values by sending an email to jkennedy@frb.gov
12 Free cash resulting from equity extraction is equal to gross equity extraction plus cash used to purchase existing homes minus closing costs associated with all three types of equity extraction. Repeat buyers derive a significant portion of the cash used to buy existing homes from the proceeds of home sales.
13 The surveys on what people do with home equity loans and the proceeds from home sales do not specify what types of assets are to be included, although presumably consumer durables are not included in either of these categories. According to the Michigan survey, the share of the proceeds from cash-out refis used for ‘real estate or business investments’ was twice as large as the share for ‘stock market and other financial investments’.
14 The NAR value of sales is calculated as the product of unit sales of existing single-family homes and condos and co-ops multiplied by the mean price of those types of homes. On average, from 1991 to 2005, the NAR/Census value of sales exceeded the ‘implied’ value by about 11 per cent, although the difference in recent years has been much smaller.
15 The numerator is from Freddie Mac's quarterly cash-out refi report. The denominator is Freddie Mac's estimate of prime conventional refinance originations. These data are available on Freddie Mac's website in the ‘Economic and Housing Research’ area.
16 In cases where a first lien is refinanced and there also is a junior lien on the property, the person refinancing has three choices: (i) pay off the first lien but not the junior lien, in which case the junior lien becomes the first lien on the property and the new loan is a junior lien; (ii) subordinate the junior lien; or (iii) pay off the junior lien at the time of the refinancing. In both the second and third cases, the new loan is a first lien. However, subordination of a junior lien takes time and typically costs at least a few hundred dollars. Consequently, in almost all cases the third possibility is the most cost effective. We assume that all junior liens on refinanced properties are repaid at the time of refinancing and that the balance of those loans is folded into the new first lien.
17 Owing to a change in the source data, Freddie Mac modified its method for calculating the cash-out in mid-2003. We use Freddie Mac's gross cash-out shares from the previous method through 2003:Q2, and projections of those shares thereafter. Eventually, we plan to incorporate Freddie's new source data into our system.
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