Tag Archives: credit card debt

Low Down Payment or Low Interest Rate?

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MainStreet.com quoted me in Consumers Should Not Assume a Lower Down Payment Is a Better Option. It reads, in part

First-time homeowners are often caught in a conundrum when they are faced with tantalizing offers of either lower mortgage rates or a smaller down payment.

The decision is much harder to make than it appears because of many variables such as the stability of your profession, the likelihood of buying another home within a few years and the long-term costs of higher payments.

While at first glance paying a smaller down payment sounds like the obvious choice for many Millennials and Gen X-ers who want to own a home, but are also saddled with student loans and credit card debt, the decision has other ramifications. A higher mortgage rate means paying thousands of extra dollars in interest alone over time.

A recent study conducted by the Federal Reserve Bank of New York found that when a lower down payment is required, it affects the demand on housing more as additional consumers are eager or able financially to purchase a house. Changes in the mortgage rate have a “modest” effect, wrote Andreas Fuster and Basit Zafar, both senior economists at the Federal Reserve Bank of New York’s research and statistics group. The study asked 1,000 households what would affect their willingness to buy a home if they were to move to a similar city and a comparable home.

When the households were offered either a 20% down payment compared to a 5% down payment, the number of people willing to pay for a house rose by 15% when the lower amount was an option.

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Advantages of Lower Interest Rates

While a lower down payment might be more appealing for a first time homebuyer, it can often result in paying more money just on the interest alone, said David Reiss, a law professor at Brooklyn Law School in N.Y. Lenders offer mortgage rates largely based on the credit score of the homeowner, so a cheaper interest rate may not always be available.

Let’s say the homebuyer is considering a $100,000 property that is paid for with a $90,000 interest-only mortgage with a 4% interest rate and a $10,000 down payment or with a $95,000 interest-only mortgage with a 5% interest rate and a $5,000 down payment.

The first mortgage means the consumer would pay $3,600 a year in interest. However, the second mortgage results in the consumer paying $4,750 a year in interest.

“That is not an apples-to-apples comparison, because the second mortgage interest payment reflects the higher loan to value ratio and the higher interest rate and it also does not take into account the tax treatment of interest payments,” he said.

Homeowners need to decide if paying additional money in interest is “worth it,” since a consumer would pay about $1,000 a year more in interest for the “privilege of paying the lower down payment,” Reiss said.

“I think that it is smart to figure out how to pay as low of an interest rate as possible, given the other financial constraints you face,” he said.

Many consumers believe there is not much of a difference between a 3.5% or 4% mortgage rate, but it can result in another few hundred dollars each month in mortgage payments, which can add up easily in 30 years.

Refinancing a mortgage in the current market conditions means your rate is not likely to decline much, so receiving a lower rate now will have a larger impact over the next 30 years, he said. After paying closing costs, many homeowners do not see the impact of the lower rates until the fourth year after the refinancing occurred.

“Since refinancing requires a large upfront cost of thousands of dollars, you need to live there long enough for it to make sense if you are only saving less than 1% on your mortgage rate,” he said.

Foreclosures & Credit Card Debt

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Paul S. Calem, Julapa Jagtiani and William W. Lang have posted Foreclosure Delay and Consumer Credit Performance to SSRN. Effectively, it argues that long foreclosure delays may have reduced the credit card default rate because homeowners in default were able to pay down their credit card debt while living for free in their homes. The abstract reads,

The deep housing market recession from 2008 through 2010 was characterized by a steep rise in the number of foreclosures and lengthening foreclosure timelines. The average length of time from the onset of delinquency through the end of the foreclosure process also expanded significantly, averaging up to three years in some states. Most individuals undergoing foreclosure were experiencing serious financial stress. However, the extended foreclosure timelines enabled mortgage defaulters to live in their homes without making mortgage payments until the end of the foreclosure process, thus providing temporary income and liquidity benefits from lower housing costs. This paper investigates the impact of extended foreclosure timelines on borrower performance with credit card debt. Our results indicate that a longer period of nonpayment of mortgage expenses results in higher cure rates on delinquent credit cards and reduced credit card balances. Foreclosure process delays may have mitigated the impact of the economic downturn on credit card default.

The authors conclude,

our findings indicate that households do not consume all the benefits from temporary relief from housing expenses; instead, they use that temporary relief to cure delinquent credit card debt and reduce their credit card balances. Interestingly, we find that payment relief from loan modifications has a similar impact to payment relief from longer foreclosure timelines; both are associated with curing card delinquency and reducing card balances.

These households, however, are likely to become delinquent on their credit cards again within six quarters following the end of the foreclosure process. Thus, the results suggest that there may be added risk for nonmortgage lenders when foreclosures are completed and households must incur the transaction costs of moving and incur significant housing expenses once again. This implies an additional dimension of risk to credit card lenders that has not been observed previously. (23)

I am not sure what to make of these findings for borrowers, regulators, credit card lenders or mortgage lenders. Would a utility-maximizing borrower run up their credit card debt while in foreclosure? Should states seek to change foreclosure timelines to change consumer or lender behavior? Should profit-maximizing credit card lenders seek to further limit borrowing upon a mortgage default?  What should profit-maximizing mortgage lenders do? I have lots of questions but no good answers yet.

HELOC vs. Cash-out Refinance for Card Debt Repayment

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CreditCards.com quoted me in HELOC vs. Cash-out Refinance for Card Debt Repayment. It reads, in part,

On paper, it may look as if it makes a lot of sense to replace high interest card debt with a low interest payment if you have home equity you can tap into. If it’s available and will ease your pay-off pain, why not use it, right?

While using a home equity line of credit (HELOC) or cash-out refinance (in which you refinance your mortgage, but tack on an additional cash payout) to rectify your debt woes might seem like a no-brainer, there are lots of factors to consider to determine which avenue is right for you or if you should go that route at all.

“One size doesn’t fit all,” says Malcolm Hollensteiner, director of retail lending sales at TD Bank. “Utilizing equity to pay down or eliminate higher interest rate consumer debt can be a very beneficial strategy, but it should be done in moderation, accessing some — not all — of your equity,” he says.

Gone are the days when banks allowed homeowners to tap into 125 percent of their home value (thanks to the lessons learned during the real estate market meltdown, which left many people “underwater,” owing more on their home loans than the value of the home). And, you’ll need to have a respectable credit score to qualify. But even with more restrictions in place now than in years past, borrowers still should tread carefully if they’re contemplating borrowing against their home.

“Although the interest rates are much lower on a HELOC or cash-out, the issue becomes that you’re taking your short-term debt and turning it into something you’re going to be paying back for 30 years,” says John Walsh, CEO of Total Mortgage Services.

And then there’s the risk factor. Before you jump on that lower rate, you have to understand that if you cannot keep up with your new payments, you risk going into foreclosure, warns David Reiss, professor of law and research director of the Center for Urban Business Entrepreneurship at Brooklyn Law School, who also writes the REFinBlog. “In other words, you are getting the lower rate in exchange for putting up your house as collateral for the debt,” he says.

With stakes this high, it’s not as simple as using a HELOC or cash-out refinance as your “get out of debt free” card. Here are the factors you need to consider.

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As you consider your options, think about both the short-term and long-term benefits and costs, says Reiss. “You can’t think of home equity as free money. That’s your retirement, money you may leave to your children or use for an emergency. It’s money that your future self may need,” he says. If you do decide to move forward, make sure you’re using your home equity wisely — paying off your debt would fall into that category, as long as you commit to smart spending habits moving forward.

Take an honest assessment of where you are in life, and think through your ability to pay off the debt in whatever form it may take. “Run some numbers, and talk this through with someone whose financial judgment you trust,” says Reiss. By being honest with yourself and becoming an educated consumer, you can figure out which option makes the most sense for you.