That is true. But then he stops making the payments. The bank either forecloses and takes the house to settle the loan, or he sells it in a short sale for $35

That is true. But then he stops making the payments. The bank either forecloses and takes the house to settle the loan, or he sells it in a short sale for $350K and the bank writes off the difference. Worst case, he has to file bankruptcy and maybe pay income tax on the amount forgiven. Either way, he still got to spend the $500K on...whatever. Now that I think about it (and these are pure anecdotes), at the time I heard tales of people using the money from refinancing to buy a smaller home with cash. Then they'd move into that and let the first house get foreclosed on (because their paid-in-full primary residence is protected in bankruptcy).