Paying down debts now can keep your
home safe if economic storm strikes
By Michael D. Larson • Bankrate.com^SM

July 20, 2000 -- Forget all that talk you've heard about Federal Reserve Board Chairman Alan Greenspan and his "soft landing." For many consumers, there's going to be no such thing.

Experts who use the term are trying to cloak reality in Econo-speak. When you cut through the B.S., they're really saying that Fed officials are raising interest rates so people will lose their jobs, spending will slow and inflation won't get out of control. That means any soft landing

-- or even worse, a possible "hard" one -- will wreak havoc on unprepared borrowers. Just ask mortgage loan officers, dot-com employees and some of the others who are already getting laid off by the thousands.

"It's pretty clear what has changed recently and that is the big increase in interest rates that the Fed has been engineering," says Dennis Capozza, a principal at University Financial Associates LLC. The Ann Arbor, Mich.-based company, which provides economic research to lenders, recently issued a report saying that default risk on subprime mortgages is nearing a 10-year high. "With interest rates going up, it trickles through everything.

"Borrowers today are taking out loans at higher interest rates relative to their income, so they're a little more stressed," he adds. "They're less able to take a shock, No. 1; and No. 2, they're more likely to get a shock."

Skies are blue, but ...
By almost any measure, consumers haven't been pinched on a widespread basis yet. Most people can still find decent work for decent pay. The stock market has rebounded substantially following a spring collapse. Interest rates have risen, but not to the double-digit rates seen in the 1980s. As a result, property values remain on the increase and most borrowers can still make their mortgage payments.

But many experts predict this benign environment won't last. Either the economy will rebound from its recent weakness, prompting the Fed to raise interest rates even further than it already has. Or, the recent slowdown will broaden as past rate hikes make their way through the system. Both outcomes could nail homeowners who don't take steps now to protect themselves.

"The Federal Reserve is trying its darndest to create a soft landing and the definition of a soft landing is it doesn't do much damage to slow the economy down," says Carol Nowka, a certified financial planner with Nowka/Grimes Financial Inc. in Grand Island, Neb. "But a slower economy automatically translates into fewer jobs."

In a recent letter she sent to her clients, Nowka added: "As a nation we have become spoiled into thinking that the 'good times' would roll on forever. We now know that is not true."

Planners recommend that mortgage and home equity borrowers consider several moves now in case the nation's economy heads south later. Among their suggestions:

Reduce luxury spending
If you have a high loan-to-value equity loan, such as one of the "125s" that raise a borrower's debt to as much as 125 percent of the value of the home, pay it off -- pronto!

Borrowers with such mortgages generally count on home appreciation to help bail them out of their upside-down financial position. But if the Fed causes the economy to stagnate and people lose jobs, home appreciation will likely grind to a halt. Some areas may very well see prices decline.

"You have to make some decisions," says Randolph J. Shine, a CFP with Shine Financial Inc. in Deerfield Beach, Fla. "Say, 'OK. We want to protect, if nothing else, our house.'

"If you happen to have one of these 125 loans, go at it with tooth and nail," he adds. "Don't go to the movies three times a week. Go once. Do whatever you can to change your lifestyle in such a way that you're maximizing your cash flow and minimizing debt."

Scaling down
If you have purchased a home with little or no money down, consider selling and trading down to a smaller property or making extra principal payments to lower the LTV as quickly as possible.

Borrowers can buy homes at conventional rates these days without paying any money up front. Some mortgage programs even give consumers an extra 3 percent of the house's value to cover closing costs.

Unfortunately, these loans make it easier for people to buy more home than they can afford. Borrowers with 103 percent LTV loans who lose their jobs in an economic slowdown aren't going to get any money out of an emergency home sale either. Even a slight decline in property values could leave them owing more than their homes are worth. They could just give up and walk away from their properties the way some homeowners did in Texas during the mid-1980s. But doing so would ruin their credit for years.

"If (the Fed) slows the economy and slows inflation, you're going to have little to no growth in house prices," says Brian Carey, an economist with the Mortgage Bankers Association of America. "That could definitely have an adverse impact on higher risk, higher-LTV loans."

If you're planning on borrowing with any kind of mortgage or home equity loan, be very careful about your debt ratio.

Lenders used to want no more than 28 percent of a borrower's gross monthly income going toward the mortgage payment and no more than 36 percent going toward all debts. Now, they routinely lend money at their cheapest rates to borrowers with overall debt-to-income ratios of up to 50 percent. That already leaves little money for everything from groceries to gas that costs twice as much as it did last year. But being leveraged to the hilt will hurt the most for borrowers who either lose their jobs or have to take lower-paying jobs due to an economic slowdown.

Sell those precious stocks
Consider selling out some stock positions or other investments to eliminate housing debt.

If there's a slowdown, especially a severe one, stocks are likely to either tread water or decline. The higher interest rates that cause the slowdown, on the other hand, will drive payments on credit cards, home equity lines of credit and some adjustable rate mortgages higher. In other words, borrowers could see the value of their savings decline at the same time the cost of servicing their debts is rising.

Even fixed-rate mortgage holders can benefit by throwing a chunk of their money toward their principal balances. At the very least, they'll lower their overall interest costs. But those who end up having to take lower-paying jobs can benefit even more. They'll be able to qualify for refinancing because even though they're making less money, their principal amounts will be small enough that their payments are still affordable.

"If you happen to be one of these fortunate people who have stock positions in the market, I would suggest you start liquidating your stock positions and start eliminating debt," Shine says. "Why not take some profits and get rid of some losers, re-examine your portfolio and do some serious re-evaluating?

"Now would be a great time to do that."

None of these moves will prevent difficulties if we get a full-blown recession. But they will gird borrowers against the lean times that may very well hit later this year and into 2001.

-- Posted: July 20, 2000