As Home Prices Rise, Consumer 'Wealth Effect' May Be Smaller

Despite rising house prices, consumers aren’t taking money out
Photograph by Steve Horrell/Getty Images

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.

Darvin Boothe, who runs a recruiting company in Tampa, refinanced a 30-year loan into a 15-year loan last month, while reducing the rate on his $690,000 mortgage from 4.75 percent to 3.25 percent. “Having a house paid off by the time I’m 55 and the kids are out of school, I don’t think it gets any better than that,” says Boothe, 40, who has two young children.

The Cheesecake Factory, among many businesses, is noting consumers’ changed attitude. “People are using cash. They’re not living on credit that they think they’re going to get out of their house,” Chief Executive Officer David Overton said in a recent call with analysts, seeking to explain why traffic at his restaurants is below prerecession levels.

Some homeowners can’t enjoy the wealth effect because banks have tightened credit so much that they’re not eligible for new loans. “Credit is going to get tighter before it gets easier,” says David Stevens, president and CEO of the Washington-based Mortgage Bankers Association.

The dwindling wealth effect has implications for Federal Reserve Chairman Ben Bernanke. The Fed may have to pump more money into the economy through purchases of government and mortgage-backed debt. Theoretically, that will provide banks with money investors can borrow to put into stocks. The problem with this approach is that ordinary consumers hold few shares. It’s the wealthy who largely enjoy the gotta-go-shopping feeling that comes with owning rising equities.

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