Most people finance their homes assuming that the housing market and the value of their homes will continue to climb at breakneck speeds. What happens if the housing market declines and the appraised value of your home starts dropping?
If the housing bubble in the US bursts just like the Internet bubble did, many overextended homeowners will find themselves in financial hot water and risk losing their homes. Here is what you can do to protect yourself in case of the inevitable market downturn.
Buy Within Your Budget
Because mortgage interest rates have been so low, many homeowners purchased larger homes than they could afford using interest only mortgage loans. The problem with overextending yourself becomes painfully evident when the market takes a downturn, interest rates rise, and your mortgage payment becomes unmanageable.
Monitor Your Loan-to-Value Ratio
If you use a home equity line of credit, always keep your loan-to-value ratio below 80%. If you keep your LTV below this level you provide yourself a healthy cushion if the appraised value of your home falls. If the value of your home falls below that of your outstanding mortgage balance you will no longer have enough equity in your home to secure the mortgage.
If you use home equity loans for any reason, borrow conservatively. If you stretch yourself too thin and fall behind on the home equity payments you could lose your home. A down economy is not a good time to borrow against home equity; the risks involved greatly outweigh any benefit your could receive from that money.
Avoid Cash Out Refinancing
In a down economy cash-out refinancing can be just as risky as a home equity loan. The less equity you own in your home the more an economic downturn will affect you. This is why adjustable rate mortgages, especially option and interest only mortgages, are so risky. If your tolerance for financial risk is low, you should refinance using a traditional, 15 or 30 year mortgage with a fixed interest rate. A mortgage with a 15 year term would allow you to build equity at a much faster rate; the more equity you have in your home the better off you will be in the inevitable economic downturn.
To learn more about building equity in your home and avoiding common homeowner mistakes, register for our free mortgage guidebook: “Five Things You Need to Know before Refinancing Your Mortgage.”