The habit of homeowners in recent years has been to keep their homes in a perpetual state of debt. There are after all, tax advantages to mortgage debt that lesser forms of debt don’t share. And houses have been—until recently at least—appreciating assets that will wipe out debt in an eventual sale. Not to worry then, load up the debt and let time and rising values work their magic—right?
Not any more! Most homeowners are now painfully aware that house prices can go down as well as up and that should call for a change in mortgage strategy. Not much can be done with mortgages taken before the housing crash, but all efforts should be made to avoid the mistakes of the past and to take a different approach based on the realities of today.
The house you buy today will determine your future
The buying decision, and how much to commit to it are the beginning of the housing debt nightmare that so many are trapped in today. If you’re not in that dilemma right now, then you’re in an excellent position to avoid ever being in it by how you buy.
Buy less house than you can afford. When people buy houses they usually buy at the maximum they can qualify for, and often a little above. But if you buy at the maximum then struggle to make your payment, you won’t be in a position to improve your situation any time soon. Better to buy a little below your means to give yourself some breathing room and use the extra for savings and debt reduction.
Don’t assume your income will increase. Looking for the best home they can afford, many home buyers become blind optimists, assuming that even if they can’t quite afford the house now, they will shortly after moving in. Safe to say many recent home buyers are now regretting that kind of thinking. Buy a house you can comfortably afford right now, and plan on using the prospect of future salary increases for improving your overall financial situation. Now is not the time to bite off more than you can chew in the housing market!
Buy with the intent—and a workable plan—to pay off your mortgage early. Since we can no longer count on eternal house price appreciation to reduce mortgages to meaningless, it’s critical to have a workable plan to accelerate pay down and eventually pay off of the loan. It’s not inconceivable that you’ll need to do that to stay ahead of future price declines!
Keep those refinances under control
It’s beyond ironic that many distressed homeowners originally purchased their homes for well below even today’s post-crash levels. Had they been content to simply pay off the original indebtedness they might not be sweating the slide. But millions of people got swept up refi-mania, stripping out any increase in equity as soon as it became available.
So we’re not doomed to repeat the mistakes of the past, here are some guidelines to enable you to refinance without increasing your mortgage liability.
Never increase the amount of your current mortgage balance. If you’re planning to refinance to lower your rate or shorten the term, be sure that you don’t increase your loan balance in the process. If your current mortgage is $150,000, then make that the maximum amount of your new loan. Avoid the temptation to increase the new loan even if “only” by a few thousand dollars. Every amount you borrow in excess of your current balance represents a raid on your homes equity and a reduction in your future security.
Never pay closing costs or escrows by increasing your new loan balance. One of the common ways people increase their new loan balances is by adding closing costs and escrow charges to the new loan balance. After all, who wants to write a check at the closing table, right? But there is a better way. It’s called “premium pricing”, which means that you pay for closing costs and escrow fees by accepting a slightly higher rate on your mortgage. This is actually the most accurate way of doing a refinance; you want to get a better rate on the new loan than you now have without paying closing costs to make it happen. If it turns out that a new loan with premium pricing to cover the closing costs presents no advantage for the refinance, then that’s you’re cue to drop the refi attempt.
Say NO to debt consolidations and home equity lines. For many years home equity lines of credit (HELOCs) were so easy to get and carried such low interest rates that they became preverbal “no-brainers”. Everyone, it seemed, was taking one out to repair and improve their homes, buy new cars and consolidate debt. Small wonder we’re wrestling with the upside down homeowner syndrome! Despite their benign-sounding title, home equity lines are mortgage debt—additional mortgage debt—and are best avoided. Debt consolidations in particular are really just a subterfuge for converting short term debt to long term debt.
Never increase the term of your current loan. In an effort to keep the monthly payment to a minimum, many people who refinance will make the new loan the longest term possible—usually 30 years. If you’re five years into your current mortgage and you recast with a new 30 year term, you’ve essentially extended your original term to 35 years. If you refinance every few years, it’s possible that your mortgage will never be paid off. As an alternative, keep the term of the new loan to the remaining term of your current one. For example, if you’re five years into a 30 year loan, recast the new one at 25 years, that way you’ll pay off the mortgage on your home in no more than the original term.
In today’s backdrop of falling house prices and uncertain economic fortunes, paying off your mortgage early may be more than just a smart move. It may just be a critical survival skill.
If you’re already underwater on your home financing, just how you handle it will depend on what market conditions are in your area and just how far under you actually are. But if you’re buying a home, or you still have equity and you’re in a position to refinance, don’t proceed unless you have a plan to pay off the new loan as soon as possible.
(photo credit: Shutterstock)
This post is from FiscalGeek staff writer: Kevin Mercadante. I’m very excited to have him contributing to the site. You can find out more about him at his own blog OutOfYourRut.com.