how-to-weather-a-market-downturn
In recent years, real estate has seemed like a can’t-lose
investment. In many parts of the U.S., housing prices have gone
up more than 70 percent in the past five years, and in a few
red-hot markets values have more than doubled.
Suppose you bought a home four years ago for $250,000 and
financed with a $200,000 fixed-rate mortgage at 7 percent. If
the market in your area has since climbed 15 percent, your home
is now worth $287,500. You’d have paid only about $9,000 in
principal while building over $96,000 in equity.
But it’s important to be prepared for a possible real estate
decline. Should the housing bubble burst, some of your equity
could disappear. And, if you’re a recent buyer who bought your
home with a low down payment, you could find yourself with a
mortgage that exceeds the value of your property.
You can’t control the real estate market, but you can do the
following things to protect yourself from a potential market
downturn:
Buy within your means
When mortgage rates are low, it can be tempting to make a low
down payment or buy more house than you can afford. However,
this makes you particularly vulnerable if the market turns,
since your equity is low to begin with.
Keep your loan-to-value ratio below 80 percent
Your mortgage principal, plus any home equity loans you may
have, should total no more than 80 percent of your home’s
current value. Not only will this get you a better loan rate and
remove the need to pay private mortgage insurance (PMI), but it
also builds in a healthy cushion if the value of your home
drops.
Don’t buy and flip
Homebuyers may get into trouble if they plan to sell within a
year or two, since they’re not building in time for the market
to recover if it drops. You have less to worry about if you plan
to stay in your home for at least five years.
Don’t stretch your home equity
A home equity loan (HEL) can be an affordable way to consolidate
debt, finance a renovation or cover other large expenses.
However, stretching your home equity too thin is risky if the
market is headed for a downturn. If you expect the market to
cool off, then it’s not the time to take out a HEL to pay for
a luxury, such as a vacation or fancy car.
Be wary of cash-out refinancing
Some homeowners dip into their home equity when they refinance,
taking out a new mortgage with a higher principal and putting
the extra funds toward a major purchase. However, just like
taking out a home equity loan, this is riskier if a market
downtown is on the horizon.
Pay down as much principal as you can
The less equity you have in your home, the harder you will be
hit if the real estate market drops. That’s why interest-only
mortgages and option ARMs bring higher risk: they do little or
nothing to reduce the loan’s principle. If you’re buying or
refinancing and are worried about a downturn (and can afford the
higher payments), consider a fixed-rate mortgage with a 15-year
term. This will enable you to pay down the principal and build
equity much faster.
Finally, remember that your home’s value is most important on
the day you buy and the day you sell. On all the days in
between, modest swings in the market shouldn’t cause too much
concern.
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