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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. |
