As Home Prices Rise, Consumer ‘Wealth Effect’ May Be Smaller | Mt Kisco Real Estate

The “wealth effect” is a term coined by economists to describe consumers’ tendency to spend more when their wealth has increased. It spurred the U.S. economy forward for decades as the market value of homes rose. It was easy for Americans to take out new mortgages and pocket the proceeds for trips to the mall or a second car. The equity extracted through these mortgages, known as cash-out refinancings, rose from $26 billion in 2000 to $321 billion in 2006. Home-equity loans, which do not require a new mortgage, also fueled the frenzy. Economists figured that every dollar increase in housing wealth produced an extra 3¢ to 5¢ in spending.

Home prices are rising again, but the wealth effect “is much smaller,” says Amir Sufi, a professor of finance at the University of Chicago Booth School of Business. Sufi reckons that each dollar gain in housing wealth today may yield as little as 1¢ in extra spending. U.S. Department of Commerce data show that consumer spending has grown at a 2.1 percent annual rate since the recession’s end, down from a 3.2 percent average for the 20 years before the slump.

Consumers now see their homes less as a piggy bank to be tapped and more as a nest egg to be secured. More homeowners are paying down the principal and shortening the maturities of mortgages. Cash-in refinancings, in which borrowers invest more of their own money in the house, outnumbered cash-outs by more than 2 to 1 in the fourth quarter, according to Freddie Mac (FMCC).