And Our Income is Falling!
I recently heard about a couple that needs financial help. They are in the real estate business and not surprisingly due to the real estate crash, their income has dropped significantly in the last two years from $10,000 a month to $5,700!
They have a 5.375% 15 year 1st mortgage which they owe about $158,000 on. The house is worth approximately $475,000- $525,000. So they have about $317,000 equity. Their monthly mortgage payment for principle, interest, taxes and Insurance (PITI) is about $3000. At first it sounds like they should be fine because at least they have quite a bit of equity but…
Unfortunately, they followed the advice of the Real Estate “Guru’s” of a few years ago and used their home equity to purchase a real estate investment. So they also have a second mortgage used to purchase land for investment purposes (but this investment produces no income). Make a mental note, investment real estate should be self liquidating not dependant on the hope of selling at a higher price.
The 2nd Mortgage is adjustable… currently at 3.25% with a balance of $192,000. they are currently paying interest only, which costs them about $530 a month. This means that they really have $125,000 in equity in the house plus whatever the land is currently worth. And their total monthly mortgage expenses are $3530. even with a $10,000 a month income they were exceeding 35% of their income in mortgage payments.
With $3530 in mortgage expenses and a $5700 income, their mortgage represents over 50% of their income and so to stay afloat they have racked up some serious credit card debt. Remember, that $3530 doesn’t include anything for reducing the credit card debt.
This is a big problem, obviously mortgage debt of 50+% is unsustainable, most banks consider about 30% the max. (Personally, I prefer less than that.)
They have looked at their options:
They can refinance the house for 30 years at 5% for a monthly payment (PITI) of $1113. They would be able to keep the 2nd mortgage but the rate would also go up to 5%, increasing their monthly interest costs on the second mortgage by about $200. But the interest on their primary mortgage would go down by about the same amount. So basically their interest payments would stay the same until they pay off the second mortgage at which point they would actually be saving interest.
They anticipate selling the land and paying off the credit card debt and working on the second mortgage.
Personally, being the conservative person I am, with a monthly income of $5700, I would not be comfortable spending more than $1425 (25% of $5700) on my mortgage (both 1st and 2nd). They have admitted to being more aggressive so perhaps they can live with a bit more.
After refinancing… their monthly payments would be $1113 for the 1st mortgage plus 5% of $192,000 or about $800. per month which totals $1913 or just over 33.5% of their income. I certainly wouldn’t feel comfortable with fixed expenses any higher than that! And I would prefer them to be even less. And that doesn’t include any provision for paying off the credit card debt or the principle on the 2nd mortgage.
In my opinion, at this point, their situation is critical… it is like a triage situation. They have to stem the bleeding and hopefully stabilize the patient until it has time to heal. They need to buy time. In this case the bleeding is the increasing credit card debt. They need to drastically reduce their monthly expenses.
Fortunately, they had a 15 year mortgage with a significant portion paid off like I suggested in other articles, so they have the option to go to a 30 year mortgage to buy some time.
A 30 yr mortgage will give them some flexibility. And there is nothing stopping them from prepaying principle once they have paid off their credit card debt (and second mortgage) or when their income rebounds. I have stressed in many articles to eliminate high interest short term debt first and then work on eliminating longer term debt. The key is self discipline, not to extend your long term debt and then dig the hole deeper by spending the savings rather than using that to eliminate the short term debt.
There is much to be said for the peace of mind that lower fixed debt brings. By that I mean that if you absolutely have to pay only say $1450 you can always pay more… but if you have to come up with $2100 and that is a struggle, the mental stress makes life hard. Especially when you don’t have a regular salary and are dependant on commissions.
But remember, in the above example we still have not allocated a single cent for covering their credit card debt. So even though it looks like their expenses have been reduced drastically it really isn’t enough to allow them to get ahead.
A lot depends on how soon they can sell the lot and how much the interest rate and “minimum payment” is on the credit card. But remember paying the minimum will just cover the interest and pretty much keep you in debt for the rest of your life. You need to pay much more than the minimum to ever get out of debt. And if you miss a single payment (even by accident) they can (and will) jack up your rates to 18% or even 24% or more instantly.
Depending on the rate they are currently paying on the credit card it might actually be advantageous to use some of their equity to pay it off. (I know, I usually say that is a bad idea) but a lot depends on the credit card rate. If for instance they are paying 18% and owe $50,000 in credit card debt that is adding $9,000 in interest to their bill every year. That amounts to another $750 a month just for credit card interest!
On the other hand, if they add the $50,000 to their 5% mortgage they will only pay an additional $268 a month (or $3216 a year) on their mortgage and of that $2500 a year is interest. So it would take three and a half years to pay the same amount of interest. But remember, their mortgage is already above the 30% limit!
Hopefully, they don’t have more than $50,000 in credit card debt. If they do, even if they roll it into the 30 year mortgage that brings their minimum monthly payment above a sustainable level.
One thing I always do is look at the worst case scenario. They are counting on selling the lot, and they really need to do that and cut that second mortgage interest A.S.A.P. Remember if they are paying 5% a year in interest, the lot has to go up 5% a year just for them to break even and that is not including what they lose due to inflation.
Yes, I usually prefer a 15 year mortgage to a 30 year mortgage. But it is much better to have a 30 year mortgage you can easily afford than to have a debt hanging over your head that leaves no breathing room. World events of the last year have shown us that bad things do happen to the overall economy and we need to arrange our affairs so as to be able to weather them when (not if) they happen.
I considered the fact that they are currently only paying interest on the second mortgage could they roll that into their mortgage? At least they’d be making minimal payments toward principle (in the first years) and would be locking in a 5% rate so it can not adjust upward against them. Unfortunately, that would add another $500 in principle payments to their monthly mortgage payment. So I don’t think it is possible. Interest payments alone are barely allowing them to tread water, unfortunately they do not have the resources necessary to reduce this debt.
Recently, we have heard talk comparing the current situation to the “Great depression”. So we need to consider a really worst case scenario. That means unemployment rates of 25%. In that case you want your fixed debt payments as low as possible. You also want your variable expenses as low as possible. So they might even consider a 40 year mortgage. Theoretically, this would lower the minimum monthly payment is even more, for those months when commissions might not come in.
Unfortunately, the current rate on a 40 year mortgage is 5.98%. So lets look at how this compares. If they have:
$158,000 1st mortgage
A 5% 30 year fixed mortgage would cost $848 in Principle and Interest (not counting taxes and insurance). But a 5.98% 40 year mortgage costs $867 in Principle and Interest! How can that be? You pay for 10 more years and actually pay more per month! That is the difference that extra 1% in interest makes. That is why it pays to refinance if you can save 1% (or in their case 0.375%), 1% can easily knock 10 years off your mortgage.
We need to remember that a mortgage can always be prepaid or refinanced, the key is how much is your contractual minimum obligation. In times of crisis you want a low minimum that you can easily make. You can always pay more but you can’t pay less!
If their situation improves, they might be able to refinance again back to a 15 year mortgage when their income picks back up. But the main reason to refinance is to lock in lower rates. You are always able to make extra payments toward principle and you only pay interest on the outstanding principle, so switching from a 30 year to a 15 year mortgage if the rate is the same doesn’t really help. It just raises your minimum payment and costs you extra fees to get the paper work done.
I hate to close on a negative note but their situation is much more critical than it looks at first. One thing that might ease their situation is looking for a swap. Rather than trying to find a buyer for the land, perhaps they could find a swap for a rental property. That way they would have income coming in to help make the mortgage payments rather than having a non-income producing piece of land. Another solution would be to downsize to a smaller house, if they can find a buyer for their current house… or as was common in the depression… “rent out a room”.
If you are in a similar situation, the key is to “run the numbers” and be realistic. What expenses can you cut? How can you increase your income? What can be sold? And do it quickly. Too often people stick their head in the sand, wait until “the 11th hour” when it is too late and then expect miracles. Usually it is just too late at that point and they end up losing what little they have left. So face your troubles head on with firm numbers and be realistic.
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