The level of appreciation on homes backing cash out refis dropped quarter-to-quarter for the first time in nearly two years, but that didn't stop home owners from tapping equity at record levels.

In the third quarter this year, 89 percent of Freddie Mac-owned refinanced loans turned over as new mortgages with loan balances at least 5 percent higher than the old loans -- the highest level in 16 years, according to Freddie Mac's Cash-Out Refi Report for the third quarter 2006.

A cash-out loan is by nature an equity-depleting loan and should home owners hit hard economic times in a market of stalled or reversed appreciation, they may not have an equity cushion to soften the blow.

However, home owners are not necessarily gambling away their equity -- the difference between the value of the home and the balance on the home mortgage.

Despite the recent housing market slow down, many home owners are flush with plenty of equity to tap.

Refinancing home owners enjoyed a median 33 percent rate of appreciation, down only slightly from 34 percent in the previous quarter, but down for the first time since the fourth quarter of 2004.

Home owners also didn't mind paying more for the privilege of tapping their equity.

One-half of those borrowers who paid off their original loan and took out a new one increased their mortgage rate by about 12 percent, or roughly three-eighths of a percentage point at today’s level of fixed mortgage rates, according to the quarterly report. That put the median ratio of the new-to-old interest rate at the highest level in 21 years -- since 1985, when Freddie Mac began tracking cash-outs.

Freddie Mac says the proliferation of adjustable rate mortgages (ARMs), popularized by the ever-escalating price of homes over the past half decade, is prompting home owners to refinance.

Homeowners are seeking cheaper ARMs now that their current loan has adjusted to the prime rate level of about 8 percent. Others are locking in rate with a fixed mortgage which could be more expensive, but easier to budget over the long haul.

Through the first three quarters of 2006, 30-year fixed mortgage rates have averaged three-quarters of a percent higher than over the same period in 2005 and now average close to 6.4 percent. Freddie Mac predicts 30-fixed mortgage rates will average between 6.4 and 6.6 percent through the end of 2007 and initial rates on 1-year Treasury-indexed ARMs will hover between 5.4 and 5.5 percent.

While home owners are busy refinancing, they are also pulling out cash for home improvements and other expenses, according to Freddie Mac.

Financial experts warn against frivolous equity-tapping behavior, say, holiday shopping.

The best use of equity money is for capital improvements and investments that provide an equal or better return on your money than the cost of the loan.

Home improvements, education for the kids and new business financing are relatively better uses of equity than, say, lavish holiday celebrations, world travel tours or a new car.

Debt consolidation and emergency nest eggs can be other wise uses, provided those uses don't become habitual.

More lenders are also offering equity loan alternatives to refinancing that are cheaper then previous equity loans.

"Banks are now starting to offer more creative financing for home-equity lines, with many offering a fixed-rate line of credit option at or below the prime rate. These fixed-rate second-lien alternatives, which protect borrowers from future interest-rate increases, may reduce interest in cash-out refinances of existing first-lien fixed-rate mortgages," said Amy Crews Cutts, a Freddie Mac economist.