As everyone knows,were currently entering a real estate market crash, where prices have already started to drop significantly. Unfortunately for many people this can have disastrous effects, possibly even causing many to go bankrupt.The good news is that today we’ll look at thesimplest and best way to protect yourself from the real estate crash, assuming you plan on holding your properties.
The largest unknown and/or neglected risk for most people is financing and refinancing. Yes, financing and refinancing! A lot of you have recently jumped into the real estate market and are new to financing. A lot of you have been in the real estate market for a while and have also just refinanced to save money, pull money out of your properties, and/or just to reduce your monthly payments. Almost everyone’s been sold on the benefits of today’s financing and refinancing, and rightfully so. We recently went through a real estate market phase were financing was very beneficial in many ways. However most people forgot to do their homework and don’t look at the details and future consequences of different financing and refinancing options.
You should definitely be VERY interested in the details and consequences of financing and refinancing if you:
- if you have a mortgage with less than 40% equity (that is your mortgage is for more than 60% of the value of your property)
- if you need to refinance your mortgage in less than 10 years.
Because when it comes time to refinance again they might be in for a very big surprise! First, if interest rates go up, as they are heading back to their historical average of 8-10%,monthly mortgage payments will increase greatly. For example, on a $250,000 property, going from a 4.5% fixed interest rate to a 9.0% fixed interest rate, the monthly payments will increase by as much as 58%. They go from $1,266.71/ month to somewhere between $1,829.20/month and $2,011.56/ month, depending on how you did your calculations (best to worse case scenario).To protect yourself from such a huge increase, you can lock your mortgage into today’s history breaking low interest rates. We probably won’t be able to beat today’s interest rates in our lifetime.
Now,assuming you can cover that additional monthly cost, will the bank be able to refinance you when your mortgage term comes up? What most banks, mortgage companies, and anyone else who wants your financing business probably hasn’t told you is that if interest rates go up, prices have to drop (the reverse is also true where if interest rates go down, prices generally go up, as we’ve recently seen in the real estate market). The general rule of thumb is that for every 1% interest rates go up, property prices have to drop by 10% to keep the same monthly payment. Although not entirely accurate, it’s close enough.
At first this might not seem so significant, but it’s extremely important. Assuming interest rates climb from 4.5% to 9.0%, a 4.5% increase, then that means thatreal estate property prices will drop by as much as 45%! It’s probably a little less when you add inflation, so let’s assume 30%, which still a very significant drop.When it comes time to refinance it in 5 years you will only be able to refinance up to the value of the property. In the past this wasn’t a big issue because prices were going up as interest rates dropped. However today, like the real estate bust of the 1980’s, it becomes a critical issue. Let’s work through a detailed example to see why.
Let’s assume you bought a property today for $250,000 with 5% down ($12,500) with a fixed in interest rate of 4.5% locked for 5 years (variable works the same here except that your monthly payments will have increased throughout rather than only when you refinance). Now let’s assume 5 years go buy and interest rates have climbed to a historical average of 9.0%. Based on the previous paragraph, we’ll assume prices have accordingly dropped 30% to $175,000 (again not unheard of if you remember the 1980’s real estate crash as well as the Japanese real estate market collapse of the 1990’s). When you go to refinance your property, you’ll still have a balance of $227,336.39 due on your mortgage, which is more than 100% of your current property’s value.
No bank will give you a 130% mortgage, especially when the real estate market is falling. Therefore you will need to cover the difference of $52,336.39 between the balance remaining and your new property valuation ($227,336.39 – $175,000). On top of that, because that only brings you to a 100% financed mortgage, you will need to add another 5-25% to cover some equity on the property.This means that in 5 years, not only will your monthly payments go up by as much as 58%, you’ll also need to come up with more than an additional 21% lump sum payment of your initial purchase price just to be able to refinance for a 100% financed mortgage, which no bank will accept. In reality you’ll need to come up with more than $60,000 just to get a 95% equity mortgage, which will be very tough in a down market.
Let’s take another example, a less severe example. Considering that interest rates have already gone up more than 1% in the last few months, a 7% interest rate in the near future should not be too surprising. In this case your monthly payments will have increased anywhere from $1,512.47 to $1,663.26, an increase of up to 31%. Your property will now drop by at least 15% to $212,500, meaning that you’ll now have to cover the difference between your balance remaining of $235,038.47 and new property valuation of $212,500, a difference of $22,538.47. Add at least another 5% equity down payment and you’ll need to come up with more than a $30,000 lump sum payment just to be able to refinance.
Therefore the greatest piece of advice I can offer you at this time to protect yourself from the real estate crash is to refinance your mortgages with today’s extremely low fixed interest rates and lock in those rates for at least 10 years, preferably more. Also, have the mortgage both transferable and assumable in case you decide or need to sell. Why 10 years? Because no real estate crash in the last 50 years has lasted more than 10 years, prices have always come back within 10 years of the start of a real estate crash. Although it’s not a guarantee, no one can guarantee the real estate market’s future,it’s a good bet that this real estate crash will be gone within 10 years or less.
Again, the details of financing and refinancing are especially important for those of you that have highly leveraged properties or that have to refinance within less than 10 years. The good news is that if you do your math and you prepare yourself ahead of time then you’ll be able to safely ride out this real estate market crash. Not only that, you’ll be in a great position to catch the next real estate market boom wave before everyone else, which is where the big money is made.
Recently I had the unfortunate experiencing of almost losing a hard drive on my computer, which means a lot of important data. Luckily for me it ended up being a memory chip that was bad, however it could have been a lot less fortunate. I know lots of you are saying I should have everything backed up, and I usually do. But if you’ve ever done a restore, you always find out that you missed something or other, usually something very important.
In any case, it made me think about some recent purchases I had made from Symantec (Norton Anti-virus) and ACDSee. Both of these companies offered something called an Extended Download Service for which they charge. Before I go on, please note that I’ve purchased these software applications therefore I find them useful and beneficial. However that being said,I think the Extended Download Service is a really good way to annoy and lose your customers!
A company that offers an Extended Download Service generally allows you to download the software you purchase for a limited number of days, usually 30-60 days. After that, it’s up to you to keep a backup copy should something happen to your computer.If it crashes, if gets infected with a virus, if an act of god destroys your computer (such as Hurricane Katrina)then you will be charged a fee to re-download it if its past the initial 30-60 days, a fee for a product that is currently available online free for new purchases. It’s the exact same download, there is no large additional cost to re-download it.
I promise you to the very best of my abilities that LandlordMax Property Management Software will NOT charge a fee for re-downloading software which you already own. It just doesn’t make sense.When your customers are their worst hour, their time of crisis, when they need you the most, you charge them for help! What a really good way to annoy them. When I’m at my most frustrated, these companies create an obstacle for me to use their software product. I just don’t get…
I can understand not providing a link to obsolete software. However if your license is up to date for the current version of the software, why shouldn’t you be able to re-download it? For example we’ve had many customers here at LandlordMax who were affected by Hurricane Katrina. One particular customer we were in contact with had lost home and had their business destroyed. With this they lost their computer, their data, and pretty much everything else. It wasn’t a very pretty picture. Should we charge these people an additional fee and make a handsome profit at their worse hour when they need us most? What if it’s not a catastrophic event, but rather their computer hardware crashed hard and they lost all their data? I’d rather be known and remembered as exceeding expectations during their time of crisis then as increasing their pain and be associated as part of their bigger more painful problem.
Be part of the solution, not the problem!
In last weeks article I suggested that your credit score can greatly affect your real estate investment property’s cash flow. Today as a follow-up, we’ll go over 7 simple tips and 5 secrets to help increase your credit score.
7 Simple Tricks:
1. Always, always, pay your bills on time. Late payments and collections can have serious consequences on your credit score. Your payment history is a major factor as it represents 35% of your credit score.
2. Do not apply for credit too frequently. This will decrease your credit score because this is a characteristic of high credit risk groups.
3. Keep your credit-card balances low. If you’re “maxed” out on your credit cards, this will affect your credit score negatively. A good rule of thumb I’ve heard several times is to keep your credit card balances at or below 25% of your credit limits.
4. Fix any mistakes you have with the major credit bureaus right away because it can take time and have significant impacts. This entails getting in touch with the lender to verify that the information is accurate. If the lender can’t confirm or doesn’t respond, then the information is removed from your credit report. Also, if you have paperwork proving that the information on your account is false, send it to the credit bureaus and keep copies of everything.
5. Hang on to your old card because the credit bureaus reward loyalty. 15% of your credit score is based on the length of your credit history, and that includes the age of your oldest account as well as the average age of all your accounts. In other words, lenders want customers who will stay around and not move their accounts to whoever has the lowest current introductory offer.
6.Don’t bother to close accounts that have had missed payments or have had collections. Open or closed, they will be part of your past credit history for some time.
7. Being self employed is not good for your credit rating, fortunately you can plan ahead (as described in the 5 Secrets section). Many lending institutions, especially banks, won’t even look at you if you’re self-employed. If you plan on being self-employed consider a corporation because you can be “employed” by the corporation, however please note that even with a corporation it generally takes at least 2-3 years of consistent income before most lending institutions are ready to talk to you again.
1. For credit cards that are “maxed” out or have balances above the 25% rule of thumb, and you have no way of reducing the balance, fortunately there are other means to bring their ratios to more preferred levels. Remember that although the rule of thumb is to have no more than 25% of the maximum balance on credit, it doesn’t state just how much that 25% amount is in real dollars. Therefore another option is to increase your maximum balance. So for example, if you have a $1000 credit card and you owe $500 on it (a 50% ratio), then if you increase the balance to $2000, your ratio is now a preferred 25%! Just remember not to use the card anymore otherwise you will lose that preferred ratio.
2. Every time you do request a loan and the lender pulls your credit report, it generally reduces your score by a few points. It is part of the credit score formula to handle people trying to apply for credit and loans to live beyond their means. As another general rule, keep your loan processes within two-week periods so that all of the credit report lookups are bundled together to appear as one single request (such as trying to achieve the best rate for a mortgage).
3. Avoid using credit card introductory offers if you can. They might help you in the short run financially, or get you out of difficult debt, but as a long term solution they will most likely hurt you. Lenders want to acquire customers that are loyal because there is a cost associated for each loan. They would rather lend money to someone who is very likely to stay than someone who has a very unlikely to stay and move their money over at the next good looking introductory offer.
4. If you have little or no credit score, a quick way to bring up your credit score is to acquire debt. If you don’t pay off any debt, then how can you show that you’re a good borrower? Acquire some debt and pay it off. I’ve seen too many people looking to get their first mortgage denied simply because they’ve never acquired any previous debt before. They’ve paid everything in cash and they’re very proud, which they should be! However, you still need to establish a track record before someone will loan you bigger amounts, such as a mortgage. You need to prove your trustworthiness. Buy a car with a loan, get a credit card, get a personal loan, and basically establish some track record. At a bare minimum, borrow at least a few times before you go looking for larger loans.
5. For those of you looking to be self-employed, it’s crucial that you get all the loans you’ll need for at least 3 years now, probably even longer. Once you become self-employed it will be extremely difficult if not impossible for several years, therefore be prepared. Now I’m not saying use it, all I’m saying is that you get it. Increase the maximum on your credit card, get that line of credit, etc. Prepare for inflation, for future needs, etc. To use the cliché, an ounce of preparation is worth a pound of cure.
Related Article: A Lesser Known Secret Tip to Increase Your Credit Score
I recently read an interesting magazine article, again this time from Business Week, about how your Fico score can affect your housing affordably. Taking that one step further, it can also greatly affect a real estate investor’s cash flow. The very same property can be cash flow positive for one real estate investor while being cash flow negative for another. How? With the aid of MyFico.com, let’s take a look at the difference in cash flow (assuming no other costs than the mortgage to greatly simplify this article).
Using data directly from MyFico.com, below is the interest rate and mortgage amount for a $150,000.00 rental property with a 30 year fixed mortgage.
As you can quickly see from the table above, there is a large difference, up to about 1.5% difference in interest rates based on the FICO score alone. The amount difference is $228/mth to the cash flow bottom line! That’s a huge difference!
In other words, a real estate investor with the highest FICO score can buy a residential rental property up to 18% more expensive than one with the lowest FICO score! That or they can make 18% more cash flow which is even better!
Therefore, another way to increase your cash flow from your real estate rental properties is to increase your own personal FICO Score.