Escape From the Money Pit - Home buyers thought they could put their house under their pillow and let the tooth fairy raise its value while they slept

Escape From the Money Pit - Home buyers thought they could put their house under their pillow and let the tooth fairy raise its value while they slept. Too bad.
By Jane Bryant Quinn
© 2007 Newsweek, Inc.


Jan. 29, 2007 issue - This could be your magic moment to save some serious money. The mortgage you chose during the heady housing boom may soon cost you more per month than you really need to pay. On home-equity loans, rates are up by 4 or 5 percentage points—far from the supercheap money you expected when you first signed up.

The tooth fairy probably made your problem worse. Buyers thought they could tuck their home values under their pillow at night to double while they slept. In that kind of dream, there's no such thing as a risky loan. But the tooth fairy has been missing in action for more than a year. If you made a bad mortgage choice, you'll have to unwind it yourself.

Two types of mortgages need special attention. First, the "interest only" loan, where you're paying the interest but not reducing the debt itself. And second, the "option ARM" that allows you to pay even less than the interest due (any unpaid amounts are added to your loan, so your debt rises over time). You usually have to start repaying the principal after three to five years. At that point, your monthly mortgage cost could jump by 50 percent to 200 percent—ready or not.

Most borrowers avoid that jolt, says Bob Visini, vice president of marketing for First American LoanPerformance, which tracks mortgage data. As long as you keep your job, your credit is good and interest rates stay stable, you should be able to refinance to a loan with better terms.

On both a new purchase and a refi, the best buy today is a fixed-rate loan, says Jack Guttentag of mtgprofessor.com, a top site for mortgage calculators and advice. On a 30-year deal, you might pay 6.36 percent. That's about the same as the rate on the popular seven-year "hybrid ARM," which is fixed for only seven years and then floats with the market. A three-year or five-year hybrid might charge 0.25 percentage points less than a 30-year fixed. But why open yourself to the risk of rising rates for such a small monthly saving?

You're probably stuck, however, if you put little or no money down and your home (after selling expenses) is worth less than the mortgages owed. "That's called 'negative equity' and it's a curse," Guttentag says. You won't be able to refinance, so prepare to pay whatever monthly amount the lender orders. You can't sell the house, either, unless you can scrape up the cash to cover the loan in full. Banks don't let you transfer the debt to your future house. To dig yourself out of this hole as fast as possible, pay extra toward the loan principal every month. You'll hate it. But you still owe the money, despite the fact that the house is worth less.

If you do have to move and can't cover the full loan, consider renting the house while waiting (praying) for real estate to improve. If you lived in the house for at least two of the past five years, you can rent for up to three years prior to the sale without losing any potential tax breaks, says tax attorney Julian Block. Up to $500,000 in profits pass tax-free for married couples and $250,000 for singles—although, for you, profits may not be in the cards.

Some other tips from the experts:

If you're making a down payment smaller than 20 percent of the purchase price, you'll have to buy mortgage insurance or else take a second loan (called a piggy-back). Until recently, buyers preferred the piggyback; it cost less than the insurance and they could deduct the interest. But the piggyback is now more expensive, says Guy Cecala, publisher of Inside Mortgage Finance. What's more, the full cost of mortgage insurance is newly deductible in 2008 for homes bought or refinanced in 2007 (the full write-off goes to married couples with adjusted gross incomes up to $100,000, or singles up to $50,000).
Refinance home-equity lines (now at 8.5 percent or more), says Keith Gumbinger of hsh.com. Tuck them into a new mortgage or get a fixed-rate second loan.

Consumers are still raiding their home equity. Last year, Visini says, two thirds of refinancings included cash-outs (that's where you borrow more than you previously owed). In states where homes are highly priced—California, Hawaii, Nevada—cash-out borrowers are refinancing into option ARMs to hold down their monthly costs. If they pay the minimum, they'll go even more deeply into debt and the tooth fairy of appreciation may not be there to bail them out. It's a risky game.
Some investors borrow against their homes to get extra money for outside investments. They expect to earn more than they're paying in mortgage interest costs. But it's not that easy. For example, say that you could pay 20 percent toward the purchase of your next house. Instead, you put zero down and invest your cash in stocks. "No-down" loans carry higher interest rates and fees than regular loans. Guttentag figures that, if you stay in the house for seven years, you'll need a 16 percent annual return to cover the mortgage's extra costs. I'll bet that's more than you thought. If the real-estate market returns to normal, home prices won't be popping anymore. Now's a good time to grab a conservative loan rather than ratchet up your risk.

Reporter Associate: Temma Ehrenfeld