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How to Keep Your Cool in a Hot Real Estate Market
by Suze Orman
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Friday, October 7, 2005
Forget floods, fires, and earthquakes. Right now the biggest threat to your home could be you.
I'm absolutely aghast at how today's housing mania is pushing consumers to make all the wrong real estate moves. The popularity of interest-only loans, rampant condo speculation, and the tapping of equity with adjustable rate loans (often to pay for extravagant lifestyle upgrades or to pay off credit card balances) are signs America's homeowners are on the verge of losing their minds.
If you don't want to end up in the poorhouse, you need to get real about your real estate.
To be honest, though, you had plenty of dangerous encouragement from a very influential guy. Federal Reserve Chairman Alan Greenspan practically rolled out the red carpet for you. His policy of keeping interest rates low has meant that mortgages have never been more affordable. And just a year ago he even pointed out that consumers have been better off using adjustable rate mortgages rather than fixed rate mortgages. You could make a good argument that the high priest of the U.S. financial markets provided mortgage lenders and consumers much of the rationale they needed to dive headfirst into adjustables.
But Greenspan's timing left a lot to be desired. At about the same time he delivered that tribute to "adjustables," he was beginning his current campaign to raise interest rates. It's a path he's expected to keep for the foreseeable future. The Federal Funds rate, the interest rate directly controlled by Greenspan, is two percentage points higher than it was 15 months ago. Adjustable rate mortgages (ARMs) and home equity lines of credit (HELOCs) are tied to that rate, so anyone who took out a one-year ARM or a HELOC in the last year or two had better be ready for a painful hike in their payments.
Nowadays, with no apparent sense of the irony involved, Greenspan is leading the warning brigade about a U-turn in real estate. In late August he went on record with a prediction that housing would cool down, saying he expects "house turnover will decline from currently historic levels, while home price increases will slow, and prices could even decrease."
It may not happen next month, this year, or even next year, but it will happen. And some regions will no doubt be hit harder than others. But wherever you live, you are downright delusional if you think there's no risk in leveraging yourself up to your ears with mortgage debt to buy a house (or refinance) with the expectation that it's going to be worth a ton more next year. And that goes double if you are using an adjustable rate loan to finance your real estate delusion. In all likelihood that rate is going to get adjusted up -- not down -- in the future.
That said, I still believe real estate is one of your smartest long-term investments. But read that very carefully: I said long term. It's the notion that you can buy today and have a 20 percent profit six months from now that's insane. So is the notion that you can count on real estate value to rise every year without any hiccups.
Here's the only thing you should count on for sure: Buy a home you can truly afford and you and your family will have a financially secure place to live. And over the years -- not months -- your home should appreciate at a pace that at least keeps pace with inflation. That's a great deal, my friends: A roof over your head and a solid investment. But if you start hyperventilating at the notion that you'll be able to retire early on the housing gains you can make over the next few years and make risky financial choices based on that unwarranted assumption, you're setting yourself up for a big fall.
Know What You Can Afford Tomorrow, Not Just Today
I have nothing against mortgage lenders, but you need to understand a mortgage lender is in the business of finding a way to sign you to a mortgage he or she thinks you are "good for" -- and not necessarily one that is good for you.
Lenders are well aware that housing prices are racing ahead of incomes, so they've been busy pushing interest-only mortgages as the "affordable" way to buy a home. By requiring you to just pay only interest for the initial term of the loan, your monthly payments will be a lot lower -- at least in the beginning.
But since when was life about where you start? It's all about the finish line and that's where many interest-only loans get downright scary.
A "regular" 30-year fixed rate mortgage for $200,000, charging 6 percent interest, will run you $1,199 a month for interest and principal. But the same mortgage in which you make nothing but interest payments will set you back just $1,000 a month. That's nearly 20 percent less.
But there's a catch. If you pay only interest for the first 10 years, then you'll have to repay all the principal over the next 20 years. Your $1,000 monthly mortgage will jump to more than $1,400 a month in years 11-30 when you have to start paying down the principal along with the interest. Put another way: You saved 20 percent for 10 years, but now have to pay an extra 40 percent for 20 years.
That's a hefty additional cost, but maybe not financially ruinous. Unfortunately, many of you are not doing these fixed interest-only mortgages. Instead, you're doing downright crazy, interest-only ARMs. This is a type of interest-only loan where your payment is set so low at the start it doesn't even cover your interest payments. So the unpaid interest is rolled into the balance that you eventually need to pay. That means you're paying interest on interest. With this kind of loan, your payment could go from $500 a month to over $2,000 when it converts!
Insane often seems too kind a term for interest-only ARMs.
Now I know how the sales pitch goes: "Don't worry about down the line. You're successful, so you'll be making more in a few years and will be able to afford the higher monthly payment." Or you'll be spinned with: "Hey, no worries, the way real estate is appreciating you'll have so much equity built up in a few years you can sell or refinance into a regular mortgage and avoid being hit with the price hike."
I say: Worry. Big time. There is absolutely no guarantee you are going to be making more money down the line, nor is it for certain that homes in your area will appreciate high enough or fast enough to get you out of the interest-only loan before the adjustment kicks in.
Interest-only adjustable rate mortgages are dangerous. If the only way you can afford to buy is with one of these loans, I'm here to tell you that you can't afford to own just yet.
If you already have an adjustable interest-only loan, watch out. We are clearly in a period where rates are going to trend higher, not lower. So even if you intend to refinance -- and you do get lucky with your equity buildup -- you could still be facing a new interest rate that is going to be a lot steeper than the 6 percent or so you can lock in today with a fixed rate loan.
Match Your Mortgage to Your Time Frame
While I think adjustable interest-only mortgages are a really bad move, I'm not suggesting everyone get a standard 30-year fixed rate mortgage. The typical homeowner moves on or refinances every seven years or so. If you think you won't be staying in your home for 30 years, then it can make sense to try out a hybrid mortgage where the initial interest rate is fixed for the amount of time you plan to stay in the house.
For example, let's say you intend to move in the next five years. With a 5/1 hybrid mortgage (also known as a "5/1 adjustable"), your interest rate would be fixed for the first five years before it morphs into an adjustable rate mortgage. The advantage is that the interest rate on the hybrid is going to be lower than on a 30-year fixed rate. On a $200,000 mortgage, you're looking at saving about $63 a month for the first five years, or $3,780. The trick is to move or refinance before year six, so you won't be hit with higher payments if rates have in fact risen.
Hybrids come in a variety of terms, including 3/1, 7/1, and 10/1. You can research these and other types of mortgages at the Yahoo! Finance Mortgage Center.
While I know many of you are already stretching to make the mortgage payment, I do want to mention a smart move for those of you with some extra disposable income who plan to stay put in your house for a long time: A 15-year mortgage. This can be especially smart if you're over 50, expect to retire in the next 15 years or so, and plan to keep the same house. Yes, your payments are going to be higher, but you'll get a nice break on the interest rate. It's typically about a half percentage point lower than the rate on a 30-year loan.
Get the Lowdown on Your Low Down Payment Options
Given lofty home prices, it's become increasingly hard to fork over the standard 20 percent down payment lenders want to see. That means more home buyers are getting stuck paying Private Mortgage Insurance (PMI). This is insurance for the bank - not for you. It provides coverage for the lenders in case lower-than-normal down payments translate into a higher-than-normal rate of borrowers who can't keep up with their mortgage payments. Any down payment below 20 percent puts you in PMI Land.
Traditionally, you paid PMI as a separate cost to your mortgage and it ran about $43 a month for every $100,000 of your mortgage. So using our $200,000 mortgage example, we're looking at $86 a month -- or $1,032 a year.
These days, however, if your lender is going to require PMI, I want you to ask about rolling the cost of the PMI into the mortgage, rather than paying it as a separate cost. A typical arrangement would be that if you make a 10 percent down payment, your PMI cost will come to about 1 percent of your mortgage amount. So your $200,000 mortgage becomes a $202,000 mortgage. That will boost the monthly cost of a 30-year fixed rate mortgage (at 6 percent) from $1,199 to $1,211. That's just $12 more a month, rather than $86 more with the standard PMI payment. Even better: Because the PMI is rolled into the mortgage, a portion of it will be deductible as mortgage interest.
And please don't listen to a lender who suggests that to avoid PMI you finance using a "piggyback" loan. Typically the way these work is that you make a 10 percent down payment, then take out a primary loan for 80 percent of the mortgage and a second piggyback loan for the other 10 percent. The problem is that the piggyback is usually a home equity line of credit (HELOC), and that means it has an adjustable interest rate. As I explained earlier, adjustables are not a smart move these days because Mr. Greenspan is ratcheting up interest rates.
Don't Flip for Condos
One of the hottest market segments the past few years has been condominiums. In fact, according to the National Association of Realtors, the value of condos jumped 57 percent between 2001 and 2004, compared to an average 25 percent rise for single-family homes. Bet you'd be surprised to know that the average condo price is now right in line with the $219,000 average for single-family homes.
But a lot of that condo appreciation and demand is coming from speculators, people who think they can make a bundle by buying a condo and then quickly selling it. That's known as "flipping." In Miami, folks are buying and flipping condos that haven't even been built yet.
The forced return to reality could be in the works already. July housing statistics showed condo prices falling for the second consecutive month, while the number of condos for sale increased.
So you need to be extra careful right now. For starters, please don't jump into condos as an investment unless you have thoroughly researched the market. Next, make sure you can handle any complications or delays that may arise. If you can't flip the condo quickly for a profit (and remember to factor in the typical 6 percent sales commission you'll need to pay to the real estate agent), are you sure you can rent it out and that the rental price will cover your mortgage costs? What about maintenance and upkeep, along with the condo association costs, property tax, and insurance? The point is, rushing heedlessly into "hot" markets, which are full of people looking to get rich quick, is one of the best ways to end up with a financial albatross around your neck.
Tap Carefully
Just because you may have built up a lot of equity in your home does not mean you should take out a home equity line of credit. Don't ever treat your home like a four-sided credit card! As far as I am concerned, tapping your equity is asking for trouble and right now it could be a ton of trouble.
First, you've got that Greenspan factor we talked about earlier. The Federal Reserve Chairman has been pushing the Fed Funds rate higher for more than a year. And, as mentioned, Greenspan has indicated he intends to keep boosting that rate.
What's that got to do with home equity? Plenty. When the Fed Funds rate climbs, so do other short-term interest rates. When you take out a HELOC, your interest rate is pegged to a benchmark short-term rate such as the Prime Rate. So every time the benchmark rate rises, your HELOC does the same.
For that reason, if you really need to tap your home equity consider a home equity loan (HEL), rather than a home equity line of credit. A HEL is a traditional second mortgage where the interest rate is fixed. That's good insulation from Greenspan.
There is a tradeoff here, which is that you immediately start owing payments on the loan. With a HELOC you only make payments on money you have actually withdrawn from the line of credit. Still, if you know you need the money for a project, such as a major renovation, the HEL is the safer bet. For goodness sake, though, don't use either one for frivolous expenses such as a sports car or five-star blowout vacations. Those are expenses that you pay for only with cash at hand. If you don't have the cash, you don't buy the car or take the trip.
And I want to reiterate a very important point: Never use a HEL or a HELOC to pay off credit card debt.
Your credit card balance is what is known as "unsecured" debt, which means if you don't pay the bill, the credit card company can't claim any of your assets. A HEL or HELOC, on the other hand, is "secured" debt. Your equity in the home is the collateral for the loan. If you can't keep up with the payments on a HEL or HELOC, the lender can force you to sell your home to raise the money to pay off the debt. So it makes absolutely no sense to take out a loan that puts your home at risk in order to pay off credit card debt.
Now, I'm in no way suggesting you can punk out on the credit card debt. That's beyond irresponsible. Just don't compound your problems by shifting your credit card debt to a loan secured by your home.
Once you know how to keep your cool in hot real estate market, you can relax and truly enjoy your home, sweet home. |
