Upside down on home? Take a deep breath

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Dear Dr. Don,
My wife and I bought a house two years ago, just before the end of the Bakersfield, Calif., housing boom. When we began investigating refinancing to a fixed-rate mortgage, our lender told us our mortgage was upside down by almost $30,000 and they wouldn’t refinance. Scary!

My wife wants to pull from savings to turn the balance positive, but what would that really gain? We have about three times our mortgage deficit in cash and market funds, but is refinancing right now worth losing a significant portion of our liquidity? Life can change quickly, but we have no immediate plans to move or sell in the near future.

Where can I go to learn about the risks and benefits so I can make an informed decision?

Mike Mortgage

Dear Mike,
It’s hard thing to realize when you’re upside down in your mortgage. In your situation, since you plan to be in the house for a while, you can take a longer-term perspective than someone who needs to sell the house and move on. Don’t rush to make additional principal payments unless it makes economic sense to do it.

Know how your adjustable-rate mortgage, or ARM, resets, the index it is priced from and the pricing spread to that index. The Federal Reserve has reduced its targeted federal funds rate by 3 percent since last August to a current target of 2.25 percent. Other short-term rates follow these Fed moves.

While there’s no telling what’s next, it’s not likely the Fed will be raising rates in 2008. You can track most ARM pricing indexes on Bankrate on its
Rate Watch page.

The decision to make an additional principal payment so you can qualify to refinance the loan should be based on two factors. The first is the expected reduction in the interest rate on the new loan. The Mortgage Professor’s Web site has a
refinancing calculator for homeowners considering refinancing an adjustable-rate mortgage with a fixed rate mortgage.

Secondly, if you’re expecting a better rate in refinancing, compare the after-tax rate of returns on your investments with the effective interest rate on the new mortgage. Bankrate’s
mortgage tax deduction calculator will help you figure out the effective interest rate on the new mortgage if you use the mortgage interest deduction on your taxes.

Conservative investors are more likely to decide to pay down the house because they aren’t earning all that much on their investments.

How much additional principal should you put down? Enough to avoid private mortgage insurance PMI, if practical, but not so much that you don’t have three to six months worth of living expenses held as a cash reserve or emergency fund.

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