What?s old is new again?there is risk in carrying a mortgage on your home! The foreclosure wave and forced short sales of the past few years have shown that paying down your mortgage?and ultimately paying it off–isn?t just desirable, but perhaps even a completely necessary step toward securing you financial future.
The risk of not paying down your mortgage
The people who are in the biggest hole right now aren?t the ones who?s property values dropped so much as the ones where the value dropped below the amount of the mortgage securing the property.
Let?s say we have two neighbors, each owning a near identical home worth $200,000. Home Owner A has a $50,000 mortgage on his home, while Home Owner B owes $180,000. A recession hits, bringing a 25% drop in home values, and lowers the value of each home owners property to $150,000.
Home Owner A may find the price drop disturbing, but unless he plans to sell the home to fund his retirement in the near future, his financial situation is largely undisturbed. Even if he loses his job or is hit by some sort of financial calamity, because he has equity in his home he has the ability to sell it to pursue what ever paths he may need to.
Home Owner B on the other hand, has a real problem. He now finds himself carrying a debt load of $180,000 on a property now worth only $150,000. If he?s forced to sell for any reason, he will not be able to close without writing a check?in this case a very big check which will probably only make his situation worse. Home Owner B is symptomatic of the distressed home owner who is highly likely to lose his home in foreclosure.
Since we now know that home prices can go down as well as up, the best strategy to deal with this possibility is to steadily and relentlessly work to pay down your mortgage.
Don?t add fresh debt to your home
The first, best way to reduce the debt load on your home is by not incurring any new debt!
Until 2007 it had become common practice for home owners to take on second mortgages and home equity lines of credit (HELOCs). The prevailing theory was that rolling various high interest debts into a single, low interest loan secured by the home made greater financial sense than paying several piecemeal.
Such consolidations typically improved cash flow immediately since the single payment was usually lower than the combination of the various loan payments. This was especially true if the interest paid on the second or HELOC was also tax deductible.
But there are two significant problems with this approach:
- It converts short- and medium-term debt into long-term debt; long-term debt has a way of becoming perpetual debt, or put another way, debt that never gets paid off, and
- Debt that is either secured by other assets (cars, boats, furniture, etc) or is completely unsecured is now attached to the home; the more debt on the home, the greater the risk in owning it.
What few people realize about debt consolidation loans is that they don?t improve your overall financial condition. You owe as much money after doing a consolidation as you did before. Even the lower payment, while a relief to your budget, is accomplished primarily by lengthening the term of payback. You?re debts don?t go away, they just become more tolerable!
Avoid seconds and HELOCs secured by your home. Whether they?re taken for debt consolidation, to finance a major purchase or even to make improvements in the home itself, any fresh debt added to your home will put you at greater risk.
Be careful when refinancing
A second popular way people increase debt to their homes is by refinancing. While the refinance might result in a lower interest rate and monthly payment, it often does so by increasing the loan balance.
It?s easy enough to see this work in a ?cash out refinance?, where you borrow out additional funds to pay for something unrelated to the home. But it?s also common in refinances where cash isn?t taken out.
In no cash-out refinances, the new loan balance typically increases by adding closing costs to the loan, or by taking out just ?a little bit of cash??maybe ?only? a thousand or two. If you?ve refinanced your home in this manner, say three times in the past ten years, you?ve unknowingly added many thousands of dollars in debt to the original loan balance.
Another casualty of refinancing is recasting of the loan term. If you purchased your home with a 30 year loan, refinanced five years into the loan and recast the loan at 30 years, you?ve effectively created a 35 loan! If you?ve refinanced and recast back to the original term several times, you could be looking at a 45 or 50 year effective term.
Since loan amortization is greater as the loan matures, each time you recast, you?re slowing the pay down process.
If you do refinance, pay your closing costs outside closing or do a no-closing cost loan where the closing costs are paid by the lender in exchange for a higher interest rate. Refuse to take cash out?even a little?and always recast the new loan term to match the remaining term of the existing mortgage.
If you recognize and accept that home prices can go down as well as up, your whole attitude toward carrying debt on it should change. Be purposeful about paying your mortgage down ahead of potential future price declines. Increasingly, this isn?t just a retirement strategy, but a survival skill!
Very good article! Many people used their homes as ATMs a few years ago. Now they are feeling the affects of those decisions.
Khaleef – Some of the people in trouble right now are those who bought with maximum financing, but what you’ve written is so true. Many had equity, but succumbed to the “prevailing wisdom” that you should suck all of the equity out of your home because otherwise it’s just dead equity. You have to wonder how many of them wish they could rewind that scenario!
Even though mortgages have relatively low interest rates, they are still debt and they put your house at risk. I have watched a lot of my friends lose their houses in the past couple of years. The sooner you pay it off the better.
One of the advantages of owning over renting is that you can pay it off, instead of paying rent indefinitely. I can’t wait to be living in my house mortgage free.
Bret – I think that’s the central issue. Debt is debt, no matter how low the rate. Low rates just make it look prettier and more “sensible”. Low rates were the forbidden fruit that drew so many into debt.
I wish everyone would put their efforts toward paying down their homes, and would have long ago. Maybe then we wouldn’t be in the economic mess we are in. (Or it wouldn’t be as bad…)
ET – Agreed. The whole debt crisis we’re in now is because people got too comfortable with debt. Having it–even a lot of it–was no longer viewed as a negative. That’s a dangerous place to be.
Kevin, great post. Like Khaleef said, people were using their homes as ATMs a few years ago and now the repercussions are here. If the 20% downpayment were enforced we’d have a lot less of this. Of course, we’d have a lot less homeownership period.
For those who can’t refi now because of the values, they can still pay extra on the mortgage and get that loan balance as much as possible!
Jason – Good point about a 20% down payment. But it also has to be admitted that if 20% were required, we wouldn’t have middle class homes costing $300k, $400k, $500k and so on. A 20% down payment on a $100k home would be no more than 5% down on a $400k home.
The whole low/no down payment game was/is an illusion that helps inflate house prices. No income verification loans did the same thing. We pay more long term so that a few more houses can be sold in the short run, and it’s gone on so long that now we call it “normal”.
(I’m sensing material for a whole other post here…)
I am on the fence about this.
Two people with houses worth $200K, one owes $200K but has $100 in the bank, the other, $100K. If they lose their job, the guy with the paid down house has no cash and has enough equity that he’s actually a target for the bank. They risk nothing by foreclosing. The guy with cash and the mortgage can use the money to get through 6 months of no job if need be. Of course, that supposes the guy who is fully mortgaged is responsible enough to be building his savings, and that may be a stretch.
I tend toward the middle ground. Focus on saving and retirement first (of course, no CC debt is a given) and once the savings is on track, a steady prepayment plan. I had a 30 year fixed, and after many refinances, have 7 years left to go, 20 years in all. But as I’ve told my story, the first 5 years had a nanny’s salary to deal with. The 7 years coincides with my daughter “Jane 2.0” going to college.
Joe – I actually agree with what you’re saying, at least in theory. But the hole in the scenario is that a person with zero equity and $100k saved isn’t in trouble, even if his house drops in value, and people who bought their homes with 100% financing didn’t usually have anything like 100k in savings.
Most natural savers didn’t bite on the zero down concept–it was mainly an enabler for the non-capitalized. The longer zero down loans were around, the more popular they became with first time home buyers, the highest risk buying group of all. At the peak in 2006 I’d heard that 42% of all homes purchased by first time home buyers were being done with zero down. We shouldn’t be surprised that the housing market has played out as it has since.
One way to encourage yourself to pay down your mortgage faster is to look at how much interest you will pay over the life of the loan. Even at today’s record low interest rates, your $200 000 home is going to cost a whole lot more if you allow the mortgage to run for 30 years. Once your mortgage is paid off, you can turbo charge your retirement savings.
Balance Junkie – Good point about the interest. Over the life of the loan that’s a staggering amount of money. I think most people look at the monthly, and if that’s tolerable, they don’t look at the rest. But as you say, there’s great opportunity to save real money once the mortgage is paid.
When we sold our paid off home 3 years ago, we put all the proceeds down on the new purchase. Many people we knew were surprised we didn’t use any to “shop”.
We did have to take a small mortgage for 15 years which will be paid off early so I can retire without any debt!
Kay – Your example is really a model for others to follow. As to the people who were surprised you didn’t use some proceeds to shop, I think that says a lot about the times we live in. We’re in a consumer culture that defines people more by what they have than anything else. Shopping with a windfall is something of a default setting. Resisting it is a skill all it’s own.
This is a great article. The biggest mistake many make is by making unsecured debt into secured debt. That is a big no-no, but so many people make it thinking that it will be easier to deal with. If you ever hit bankruptcy court, it is much easier to get rid of any debt unsecured than dealing with secured. Just leave your mortgage alone unless you are refinancing within a few years of your original mortgage origination.
Hi Grayson–It also coverts short- and intermediate-debt to long-term debt and that increases the chance that you will never get out of debt.
Too many people also got caught up in bidding wars where they ended up paying more than list price for a house. The realtors encouraged that because they got a higher commission and the appraisers for some reason went along with it as well. When the bubble burst, people found out that their houses weren’t worth that high amount after all so they got angry and chose to walk away from a house that a short time earlier was – in their opinion – worth what they paid for it. Other people over spent on granite counters and stainless appliances without having the money in the bank that would allow them to carry a loan that was required to get what the Joneses had. Combine all of that with low or no down payment and liars loans you have a disaster in the making. Unfortunately, the government is once again encouraging banks to accept lower down payment and worse debt to income ratios in the supposed effort to jump start the housing industry. If they’d keep their noses out of it, the industry would recover in a slower but more realistic manner. As it is, some people will end up in the same position all over again, having learned nothing from the original disaster.
Hi Kathy – I think the basic problem is that the housing market is addicted to easy financing, and without it, it just doesn’t work. When I was in the mortgage business (thru 2008) I realized that the market was running on liar loans and 100% financing, and that’s a recipe for disaster – as we’ve seen. But you make an excellent point on the relentless home improvements. $50,000 remodeled kitchens for people who don’t even cook, upgraded landscaping, wood floors, wood blinds, finished basements in 5,000 square foot homes (as if they really needed more space). It had/has to end badly.