Smart Moves in a Changing Home Mortgage Market
For years, it seemed that buying real estate was a sure thing and that property values would continue to go up forever. Borrowers stretched to purchase homes they couldn't afford, using options like interest-only mortgages and adjustable-rate or balloon mortgages with initially low payments. These homeowners enjoyed massive appreciation of their homes' values, sometimes making huge gains within a year or two.
The Mortgage Market Backfires
Unfortunately, the bubble burst, causing a mortgage crisis in 2007 and 2008. This catastrophe resulted in the collapse of several major banks, forcing the government to bail out several companies, including Citibank and AIG. Experts say that this crisis was spurred by:
- A subprime mortgage market
- Decline in property values
- Popularity of "no-income-no-asset loans" (people purchased unaffordable homes and banks didn't verify borrowers' income)
These homeowners initially planned on refinancing or selling their homes for a profit using home equity they'd accumulated due to rising property values. Instead, however, they found themselves coping with rising interest rates and unaffordable payments, and unable to sell their homes for how much they owed. Further complicating the issue, most of these homeowners hadn't paid a down payment or made large enough payments to build up sufficient equity.
To avoid this situation, you'll want to make smart choices on home loans and purchases and compare mortgages before deciding. Although you can't control home prices, you can protect yourself from downturns in the mortgage market with these strategies:
Compare Mortgages and Don't Go Overboard
When rates are low in the housing market, it can be tempting to make a low down payment or buy more house than you can afford. This may leave you vulnerable if the home mortgage market turns, since your equity will be low to begin with.
Maintain a Reasonable Loan-to-Value Ratio
Your mortgage principal, plus any outstanding home equity loans, should total no more than 80 percent of your home's current value. Not only will this get you a better loan rate and eliminate Private Mortgage Insurance (PMI), but it will also build a healthy cushion if your home's value drops in the mortgage market.
Don't Sell Your Home Just Yet
Some homebuyers may get into trouble if they plan to sell within a year or two, and they don't allow time for the home mortgage market to recover. Stay in your home for at least five years to improve your chances of weathering economic storms.
Keep an Equity Stake
While a home equity loan can be an affordable way to consolidate debt, finance renovations or cover large expenses like college tuition, stretching your home equity too thin is risky; you could end up owing more than your home's worth. Banks may also cut lines of credit and home equity loans if property values fall, causing the need to scramble for cash. In order to avoid risking your home, experts don't recommend using home equity loans for luxuries like new cars or expensive vacations.
Be Careful With Cash-Out Refinancing
Some homeowners dip into their home equity by opting for cash-out refinancing, but taking cash out can result in a higher principal balance on the new mortgage. Just like taking out a home equity loan, this is quite risky in a home mortgage market downturn.
Build Equity Faster
The less equity you build in your home, the more vulnerable you'll be if mortgage market declines. Interest-only mortgages and option ARMs are risky, since they do little or nothing to reduce your principal balance. If you're buying or refinancing and you're worried about a downturn (and can afford the higher payments), compare mortgages and consider a fixed-rate mortgage with a 15-year term.
A fixed-rate mortgage allows you to pay down principal and build equity much faster. Remember that your home's value is most important on the day you buy and the day you sell. In between, modest swings in the home market shouldn't cause too much concern.
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