The top of the cash out and spend activity was in 2002 when nearly$200 billion was refinanced out of the cumulative American homeequity. The refinancing craze slowed some in 2003 and 2004, but it isstill an ongoing problem.
For those of you who are not involved, or have not thought about itin a while, allow me to explain through an example. Let's say thatSam bought a house 10 years ago for $100,000, paying 8.5% interest.Last year, he decided he wanted to do some work around the place, addon a room, and that sort of thing. The problem was his lack ofsavings prevented him from paying for the improvements out of pocket.
What Sam decided to do was what many home owners have done in thepast five years - he borrowed against his home's value. Today, thevalue of his house is nearly $150,000 and he owed $70,000 on themortgage. With a refinance loan, he borrowed $110,000 at 6.25%interest. $70,000 paid off the old loan, $20,000 covered the repairsaround the house, $6,000 paid for the best vacation in his life, and$14,000 paid off his credit cards.
Sounds like Sam did pretty good, doesn't it? In fact, as much as 50%of cash-out refinancing is spent on home improvements and personalconsumption, this according to the Federal Reserve. Most of the restwill go to pay off credit card and personal loans.
I have nothing against borrowing from your homes value to pay offyour debt, if you have the cause of debt under control. If you don'thave your spending under control, in a few years you will still havethe mortgage plus more credit card debt.
How do you get control of your spending? A spending plan is the onlyway. You have to plan where your money is coming from, where it isgoing, and how you will use it to pay off your debt.
Am I saying Sam should have left his mortgage at the 8.5% interestrate and forgot about home improvements? No, I think that if Sam hadbeen serious about his lifestyle, he would have done several things:
1. He would have refinanced for the lower interest rate and takenonly the cash necessary to improve the house.
2. Sam would analyze his spending to see why he racks up more debton his credit cards every month and stopped that spending.
3. He would find areas in his lifestyle to cut back so as to free upcash to pay off his credit cards as quickly as possible.
4. After the cards were paid off, the extra money would then be ableto go into either a savings plan, or to pay off his mortgage faster.
5. No matter what, borrowing against your home for a vacation islike going to the racetrack and betting on the horses. It might befun, but you still have to pay the money back.
When we go into debt, we are assuming that the future will be liketoday, if not better. That is to say, we assume our job will still bethere tomorrow and the next paycheck will be just as large and willprovide enough resources to make the debt payment.
The recession beginning in 2000 has shown that the economy canchange. The old proverb of "What goes up come down" still holds true.Housing values have been rising across much of the country at ratesnorth of 9% for several years. This rate will surely have to end, andpossibly reverse some day. This could catch you in a situation ofbeing in an upside down home - you owe more than your house is worth.
You need to start being proactive in your debt planning. Everyonehas heard it before, but it needs to be said again, and again, andagain until everyone understands. Debt is debt, no matter if it issecured by your house, your car, or a personal guarantee to repay thecredit card company. You owe the money.
To effectively argue that not all debt is bad, you have to be ableto meet three criteria:
1. The item you are buying is an asset that could produce income orappreciate in value.
2. The value of the item is greater than the debt owed against it.
3. The repayment amount will not put undue strain on the budget.
If you are already in debt, now is the best time for you to startpaying it down. Use your tax refund, your bonus, or even a garagesale to get the money necessary. The longer you wait, the more youhave to pay in interest charges.
I know there are people who disagree with me; some of them arereally smart economists who think what I say is gloom and doom notbased in reality. In response to their skepticism and "spend it ifyou can borrow it" mentality I have only one question - How much ofyour stock portfolio survived the correction of 2000 - 2002?
The economy is an unpredictable thing. Jobs are created and jobsdisappear. Housing values go up for a while, and they can go down.Things happen that affect our lives all the time, so we need to be asprepared as we can be.
This means to stop increasing your debt load. Being prepared meansyou are paying off all of your debts, preferably with the SnowballMethod. Using this method, you pay a fixed amount to on everythingbut the smallest debt which receives the minimum plus all the extracash you can push towards it. Once that debt is gone, close theaccount and roll the money over to the next smallest debt. Do thisuntil you are completely debt free.
Even if your job survives the next economic shake down, and yourhouse does manage to hold its value, being debt free is a worth whilegoal. Calculate it into your spending plan and work for it. Theeffort you expend will be rewarded by the peace of mind andconfidence that comes from knowing you are free of debt.
That is why you should not bet the house. To be master of your owncastle requires owning the title free and clear.
Roger Sorensen
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