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.