Financial Literacy 2007 - Home equity
home equity
4 easy steps to less debt

The plan

Cut the spending deficit. Cathy's plan must start with bridging the wide gulf between her monthly income and monthly expenses. Recently, she increased her paycheck withholding, but she should be reducing her paycheck withholding. She claims her daughter as a dependent every other year, and 2007 is a year she gets to claim her, which will result in a larger tax refund. With all of the borrowing Cathy is doing to make ends meet, it's silly to have additional money withheld and wait on a big tax refund next year. Case in point, she received a $1,800 tax refund last year and that was the year she didn't get to claim her daughter as a dependent!
Cathy Failor

The challenge: Upside down in home with an ARM and home equity loan; income shortfall every month

The plan: Boost income and slice spending to cut debt load and free up equity.
After adjusting her tax withholding to an appropriate level, Cathy must slash expenses in an effort to pare the $500-plus monthly deficit. Halt the 401(k) and IRA contributions. She won't be passing up any free money as the employer match doesn't take effect until January 2009. While it pains me to recommend this step, it is a testament to her need to eliminate the monthly red ink and reliance on debt.

Next, sell the time share! The last thing she needs is a money pit like that chewing a hole in her monthly budget. She spends roughly $134 per month on the time share, between the loan and the maintenance. She only uses it sporadically. Regardless, this is something she simply cannot afford.

To that end, it is important to do the following.

Trim household expenses -- some radical steps will be needed. Pack, rather than buy, her daughter's school lunches. Institute a modest allowance and shift some of the decision-making on her daughter's purchases and entertainment to her daughter. Suspend the charitable giving and the satellite TV. (Hey, I'm serious about this!) Get a better grip on miscellaneous expenses and ATM withdrawals by slashing this in half.

All of that will get her back to break even. Then, stop using credit cards!

Debt overload
Home equity plan$33,000
Credit cards$11,000
Personal loan$13,000
Auto loan$6,000
*plus a mortgage

Drowning in home debt: ARM + home equity loan

Getting back to break even every month is one thing, but what about the inevitable payment increase on her mortgage in March 2008?

If current interest rates were to hold into next year, Cathy's monthly payment would rise approximately $105 next March. Her mortgage is a 5/5 ARM, meaning that after the March 2008 rate reset, her payment will remain the same for another 5 years.

Because she owes more than the home is worth, refinancing isn't currently in the cards. This might change, however. Fannie Mae and Freddie Mac have announced new loan programs designed to help borrowers like Cathy. She must keep making the mortgage payments on time to have the option of utilizing one of these programs for a potential refinancing later this year. Should such a refinancing opportunity arise, she should seize it.


Possible relief on horizon

For example, if Cathy were able to refinance both her mortgage and home equity loan at a rate of 7.5 percent, she could save about $130 per month and add some much needed stability to her monthly budget. The benefit would come from spreading both her first mortgage and high-rate home equity loan over 30 years. While this would substantially cut the interest rate on the home equity portion of that debt, a rate of 7.5 percent is about what she can expect when her mortgage resets next year. If her lack of equity cushion prevents her from refinancing, she should be fully prepared for the alternative scenario of seeing her payment rise following the adjustment next March. That means finding a way to carve another $105 per month out of expenses between now and next March.

Create more family income

With limited ways to further cut expenses, Cathy needs to boost her income. She might consider working overtime or a second job. Or, do additional work from home, such as tutoring, transcribing legal documents, consulting and participating in focus groups and research surveys. Hold a yard sale to sell unneeded possessions.

She could consider renting out a room in the home to a trusted friend or relative. Or rent out the entire home if she could move in with a relative or friend for low or no rent. For example, if Cathy could rent the home for $1,000 and pay someone else rent of $500 per month, she'd bring in an additional $500 per month. Unfortunately, if she does rent her home, she is unlikely to command a rent high enough to cover all the costs because of that burdensome home equity loan.

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