The top of the cash out and spend activity was in 2002 when nearly $200 billion was refinanced out of the cumulative American home equity. The refinancing craze slowed some in 2003 and 2004, but it is still an ongoing problem.
For those of you who are not involved, or have not thought about it in a while, allow me to explain through an example. Let's say that Sam bought a house 10 years ago for $100,000, paying 8.5% interest. Last year, he decided he wanted to do some work around the place, add on a room, and that sort of thing. The problem was his lack of savings prevented him from paying for the improvements out of pocket.
What Sam decided to do was what many home owners have done in the past five years - he borrowed against his home's value. Today, the value of his house is nearly $150,000 and he owed $70,000 on the mortgage. With a refinance loan, he borrowed $110,000 at 6.25% interest. $70,000 paid off the old loan, $20,000 covered the repairs around the house, $6,000 paid for the best vacation in his life, and $14,000 paid off his credit cards.
Sounds like Sam did pretty good, doesn't it? In fact, as much as 50% of cash-out refinancing is spent on home improvements and personal consumption, this according to the Federal Reserve. Most of the rest will go to pay off credit card and personal loans.
I have nothing against borrowing from your homes value to pay off your debt, if you have the cause of debt under control. If you don't have your spending under control, in a few years you will still have the mortgage plus more credit card debt.
How do you get control of your spending? A spending plan is the only way. You have to plan where your money is coming from, where it is going, and how you will use it to pay off your debt.
Am I saying Sam should have left his mortgage at the 8.5% interest rate and forgot about home improvements? No, I think that if Sam had been serious about his lifestyle, he would have done several things:
1. He would have refinanced for the lower interest rate and taken only the cash necessary to improve the house.
2. Sam would analyze his spending to see why he racks up more debt on his credit cards every month and stopped that spending.
3. He would find areas in his lifestyle to cut back so as to free up cash to pay off his credit cards as quickly as possible.
4. After the cards were paid off, the extra money would then be able to go into either a savings plan, or to pay off his mortgage faster.
5. No matter what, borrowing against your home for a vacation is like going to the racetrack and betting on the horses. It might be fun, but you still have to pay the money back.
When we go into debt, we are assuming that the future will be like today, if not better. That is to say, we assume our job will still be there tomorrow and the next paycheck will be just as large and will provide enough resources to make the debt payment.
The recession beginning in 2000 has shown that the economy can change. The old proverb of “What goes up come down" still holds true. Housing values have been rising across much of the country at rates north of 9% for several years. This rate will surely have to end, and possibly reverse some day. This could catch you in a situation of being in an upside down home - you owe more than your house is worth.
You need to start being proactive in your debt planning. Everyone has heard it before, but it needs to be said again, and again, and again until everyone understands. Debt is debt, no matter if it is secured by your house, your car, or a personal guarantee to repay the credit card company. You owe the money.
To effectively argue that not all debt is bad, you have to be able to meet three criteria:
1. The item you are buying is an asset that could produce income or appreciate in value.
2. The value of the item is greater than the debt owed against it.
3. The repayment amount will not put undue strain on the budget.
If you are already in debt, now is the best time for you to start paying it down. Use your tax refund, your bonus, or even a garage sale to get the money necessary. The longer you wait, the more you have to pay in interest charges.
I know there are people who disagree with me; some of them are really smart economists who think what I say is gloom and doom not based in reality. In response to their skepticism and “spend it if you can borrow it" mentality I have only one question - How much of your stock portfolio survived the correction of 2000 - 2002?
The economy is an unpredictable thing. Jobs are created and jobs disappear. Housing values go up for a while, and they can go down. Things happen that affect our lives all the time, so we need to be as prepared as we can be.
This means to stop increasing your debt load. Being prepared means you are paying off all of your debts, preferably with the Snowball Method. Using this method, you pay a fixed amount to on everything but the smallest debt which receives the minimum plus all the extra cash you can push towards it. Once that debt is gone, close the account and roll the money over to the next smallest debt. Do this until you are completely debt free.
Even if your job survives the next economic shake down, and your house does manage to hold its value, being debt free is a worth while goal. Calculate it into your spending plan and work for it. The effort you expend will be rewarded by the peace of mind and confidence that comes from knowing you are free of debt.
That is why you should not bet the house. To be master of your own castle requires owning the title free and clear.
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