A new study reported in the Wall Street Journal concludes that “a significant share of foreclosures came from people who bought their homes before 2004.” Why did these homes sink underwater? Was it rising interest rates? Falling home values? Risky mortgages?
Not exactly. The real reason?
“These homeowners aggressively used their homes as ATMs, extracting cash by refinancing into larger loans or using home-equity loans.”
The study, which focused on homes in California, revealed that home prices for early buyers – even after the real estate crash – had risen enough in the Golden State to give 90% of these homeowners positive equity in their homes, meaning the homes should have been worth more than what the homeowners owed on the mortgage.
So what went wrong?
“Enter the home-equity loan and the cash-out refinance, in which borrowers refinanced into a larger loan, extracting equity to fund everything from college tuition and medical bills to dinners out and vacation trips,” writes Journal reporter Nick Timiraos.
Here’s the startling conclusion. If they had not taken cash out of their homes, fewer than 10% of homeowners studied would have been underwater.
“The bottom line: equity extraction was responsible for around 80% of defaults among homeowners who purchased their homes before 2004, representing around 30% of all defaults between 2006 and 2009,” says the study.
So what can we learn from the mistakes of the last decade?
Keep borrowing under 80% of your home’s value
Be very cautious taking equity out of your home via a refinance or home-equity line. One guideline is not to exceed a 80% loan-to-value ratio, meaning the total loans on your home should be 80% or less of your home’s market value. Lenders may not always have your best welfare in mind (surprise!). Just because someone will lend you the money doesn’t mean the loan is sound, or that you will have the means to pay it back.
Beware the home improvement trap
It’s one thing to refinance if you can reduce your interest rate and monthly payments; it’s quite another (and much more dangerous) to refinance to tap equity in your home and increase your indebtedness. So beware of using home equity to pay for expenses such as home improvements or repairs. Everyone likes to argue that the improvement will increase their home’s value, but that isn’t always the case. “You could be in trouble if your home’s worth doesn’t increase or if real estate values fall — leaving you owing more than your house is worth,” warns Realtor.com. And borrowing more increases your monthly payments, which you may not be able to afford.
Payoff strategies for home equity loans
We’ve seen clients get into trouble with home equity loans that require low, interest-only monthly payments. Since there is no monthly repayment of principal (e.g. amortization), the loan balance does not decrease over time, until … KABOOM! It’s suddenly due in full. And guess what? The borrower doesn’t have the money to pay it off.
There are a couple of ways to deal with this. Even if your home equity loan doesn’t requirement monthly principal repayment, make sure to include extra funds with each monthly check so you start trimming down the balance over time. We’ve also helped clients get rid of their home equity loans by combining them with their primary mortgage and refinancing the whole package, often reducing their overall mortgage interest rates and eliminating the repayment uncertainty at the same time.
Don’t bite off more than you can chew
Here’s the bottom line. Mortgages can provide you with a great tax deduction, but the goal is to reduce the mortgage over time, not see it balloon as you extract money from your house to pay for things your salary doesn’t cover. If your home goes up in value, be happy. That growth will increase your net worth and provide you with additional security in retirement. Think of it as extra money in the bank … maybe. Don’t pull out every dollar and spend it on stuff you really don’t need, at the price of more IOUs to weigh you down in retirement.