The perfect storm is brewing on the horizon -- clouds are forming, lightening flashing, thunder booming, wind whirling. Is it going to be a twister that wipes you out or a summer thunderstorm that only brings much-needed rain? You determine the outcome.
What is that perfect storm?
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Mortgage rates remain historically very low but are beginning to rise, so the mortgage industry has responded with innovative mortgage products.
When exotic mortgages meet a hot real estate market, someone's eventually going to get sucked into a tornado of spiraling debt. Sow the wind and reap the whirlwind. Don't let it be you.
It doesn't take an irresponsible fool acting recklessly to get into trouble. Very smart, well-meaning people can find themselves in a pickle too. Take a peek.
Assume we have a couple looking to "move up" to a larger home. They have $20,000 for a down-payment after selling their current "starter" home. They've determined that they can afford an $1,100 mortgage payment at the absolute maximum (principal & interest). At the going rate of 6.25%, that means the maximum principal amount they can borrow is $179,000 with a 30-year fixed mortgage. So far so good. They set off to find their new home.
Reality quickly sets in.
The hot real estate market that helped them capture equity gains in their last home has also priced many other homes out of their range -- by about $25,000 more than they can afford. Now things don't look so rosy.
"Not to worry," says the loan officer. "We've got a new loan program with a great low rate that remains fixed at 5.00% for the first five years and then adjusts in year six and every year thereafter."
With those terms, the couple can afford a mortgage of $205,000 with a monthly payment of exactly $1,100. What a miracle! Sure, things could get dicey in five years but by then the couple may move again or perhaps the husband will get a promotion or better job. Five years is a long way off. They want a bigger home now!
Fast forward to 2010.
The family is still in the house and not planning to move. The husband did get a promotion but the pay increase wasn't all that substantial. Things are looking good. The only problem is that their mortgage interest rate is about to adjust to 8.00% with a new payment of $1,453. That stretches them beyond their limit. They can't afford the payment any longer.
Here's where trouble begins.
In order to pay the extra $353 toward the mortgage each month, the family starts to use other debt to cover their living expenses. The tool of choice is usually credit cards. After awhile the debts begin to pile up -- an unexpected car repair here, new furnace there, and before you know it they are in a tailspin. The next step might be a home equity loan or borrowing from a retirement plan. Eventually the house of cards collapses. Putting off today's problems until tomorrow never works when it comes to debt. It happens all the time. Just ask Lender's Slave.
But couldn't they just move -- maybe downsize a little bit? Sure. But what if housing prices have fallen slightly -- say a modest 5%?
That means their $225,000 house ($20,000 down + $205,000 loan) now sells for $213,750. The principal balance on their mortgage is $188,250, meaning at best they will net $25,500 from their home. Factor in realtor commissions of 6% and that subtracts $12,825 leaving them with a net of $12,675. It's never good to go backwards but at least they can escape with something!
They will still have the problem of finding somewhere to live and, if they buy another home, of having a high interest rate mortgage.
It could be worse.
Home prices might fall 10%. The husband doesn't get a promotion but instead loses his job or is laid off temporarily. Or, maybe he suffers a prolonged disability. These things happen to good people all the time. And then the wheels come off the cart.
Here are a few lessons to consider:
First, using an exotic mortgage product to live beyond your means is inappropriate. The couple in my example couldn't afford the home they purchased. That's why they got into trouble. The mortgage gave them a false sense of well-being.
Second, falling real estate prices tend to burn people at critical moments in life -- losing a job, moving for another job, disability, debt problems, etc. A forced sale at the wrong time can be devastating. Don't assume real estate prices will keep rising forever or even hold their current values. You may not necessarily get what you think your home is worth when it's time to sell.
As Solomon said in Proverbs 22:3, "The prudent sees the evil and hides himself, but the naive go on, and are punished for it." Think ahead about realistic downside scenarios with any mortgage you consider. Are you prepared to handle the consequences?
Be prudent and avoid the perfect storm.
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