Build Equity in Your Fixed Rate Mortgage
Think very carefully before you take out any equity on your home. The same goes for accepting an adjustable-rate-mortgage (ARM). Do not assume housing prices will continue to go up. Relative to your income, housing prices will go down everywhere in the country for the foreseeable future.
Hopefully this will mean inflation, so that people working at McDonald’s will be making $100,000/year in the next decade or so.
If this scenario happens, it is critically important that you have as little credit card debt as possible and a fixed rate mortgage. Interest rates and incomes will go up far faster than home prices. If you are making 10% more each year and your interest rate is only 6%, you will soon be in great shape. If you have an ARM, then your mortgage payments will increase right along with your income, negating any benefit you might have seen had your rate been fixed.
If you believe this scenario will come to pass, you must lock in your rate as soon as possible. Call your lender now. Because if you believe this will happen, so will investors. The more investors believe their money will be more valuable tomorrow, the harder it will be to get them to lend you that money today — at least on a fixed rate loan.
The other possibility is recession. Many of us are young and lucky enough to have never worked through one. A recession is far more likely today than it was in June. If that happens, then every $300,000 home in the United States will tank. No one can say how low: $200,000? $150,000? $100,000? This is already happening in extremely speculative markets like California and Florida. It will be terrible if the problems spread to the entire housing industry.
Washington Mutual recently announced that the jumbo loan interest rates would start at 8%. In California, with the median home price being over $500,000, a large chunk of the loans are jumbo (any loan that’s over $419,000 is termed as jumbo in California) loans. As rates go from 6% to 8%, the 2% jump in payments represents a 33% jump in the monthly payments. This means less people will qualify for these loans and real estate prices will fall more than they already have. There’s absolutely no chance that the real estate market in California or in other grossly inflated areas will improve next year.
California’s economy is often a leading indicator for the rest of the country. The housing industry is in a world of hurt. American Home Mortgage has lost 98% of its value since May. Countrywide Financial has lost almost 50%. The Fed has been trying to keep things from getting out of hand. Good thing, last week Washington Mutual was down 25% on the year. Now this is only 15%.
Should a recession happen, incomes will drop. During a recession, a typical person who made $100,000 one year may only make $90,000 the next. If that person had taken out another $50,000-$100,000 in equity at the top of the market, he will have a very hard time keeping current with his mortgage payments. Most of us buy the biggest house with the largest possible monthly payments we can reasonably afford. What was once reasonable will become less and less so as his income drops every year — perhaps $300-$1000 less per month — leaving that much less to pay his mortgage.
The most dangerous part is that he will have a mortgage he cannot afford backed by an equity that is dropping value. Normally if the economic situation changes for a person and he can no longer afford his mortgage, he can sell his home, clear his debts and relieve the pressure. Not true during a recession. His mortgage company may well have determined his home to be worth $350,000 before, but he can only sell it for $250,000 in today’s market. Even after selling his home he will still have a $100,000 debt owed to the bank — more than a quarter of the original (now unaffordable) value. He has two choices: declare bankruptcy or else buy or rent a substantially smaller home, one that he can afford and still pay down the sizable remainder of his unaffordable mortgage.
A person who has built up large amounts of equity in his home will be largely unaffected. If a person has $200,000 of equity on a $350,000 home, and then home drops to $250,000, he can sell the home, clear all his debts and still have $100,000 cash left to put towards the down payment of another home. Since every other home will have dropped substantially in value, that $100,000 cash will go much further.
Once the market improves and prices go up, he will recover all he lost when he sold. We just don’t know how long it will be until the market improves. Assuming a person with no equity can whether the storm — which could take many years — he will be no worse off than someone with equity. But given that his fragile financial situation is what put him into a no-equity loan to begin with, weathering the storm is likely to be an extremely stressful situation.
Keep the faith and good luck.