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Bryan has just discovered one of the newest wrinkles in home mortgages. Many new and creative financing methods are available to help people afford their dream home. But some of them include hidden risks that can make them a potential time bomb for the homeowner. And this type of mortgage could be one of them.
According to the US Statistical Abstract, about 4 millions homes were sold in 1996. And first time homebuyers paid a median price of $130,000 to buy into the American dream. So a lot of people are deciding what type of mortgage is best for them.
Before Bryan or any family buys a home, it's important to know that they can afford it. Not just today, when they hope to get mortgage approval, but for the entire time that they own the home. If, at any time, they can't keep up with the payments they could lose everything they've invested in that home.
Most of us think of a downpayment as a hurtle to jump before we're allowed to buy a home. The idea is to get it as low as possible. But, the downpayment is more than that. It's the homeowner's cushion against decreasing home prices.
In 1996, the average downpayment was 19.5% of the purchase price of the home for all homebuyers, but first timers only had 12.4% available according to the Chicago Title Insurance Company.
Obviously, many people are finding it hard to save enough money for a downpayment. Take the average first time buyer. They spent $130,100 on a home. At 12.4% down, that's $16,132 for a downpayment. Add the $3,000 or so they'll need for closing and that's a lot of money for a young family to save.
That's where Bryan's question comes in. Suppose you had some money in the stock market. You expect your stocks to go up and you don't want to sell them. So a friendly mortgage company offers to use your stocks as a downpayment. It's sometimes called an asset-integrated mortgage. Is it a good idea?
If everything goes as planned, it could be a fine idea. You can continue to watch your stocks increase in value. You can delay paying taxes on your gains. Your mortgage payments are higher than with a conventional mortgage, but you sell off a few shares occasionally to make up the difference. And everyone lives happily ever after.
But what happens if everything doesn't go as planned? Then this type of mortgage can quickly turn the American dream into a nightmare. Here's how.
Let's suppose that the stock market suffers a 20% correction. The $16,000 worth of stocks suddenly are worth $12,800. You don't want to sell your shares now, but the mortgage payment is still due. Is there someplace else that you can get the money?
If not you'll probably be forced to sell the stocks. And if you sold the stocks at a profit, you'll need to pay income taxes on the gains. As my kids would say, it's just not fair!
But, there's an even worse possibility to consider. Typically, when the stock market drops, it's a sign of slower economic activity. That means that unemployment will increase and home prices will drop. It's possible that those higher mortgage payments will hurt during a time when your job is less secure. A job loss could force you to sell your home when prices are dropping.
I can hear many of you saying that the stock market isn't very likely to drop by 20%. Let me remind you that market professionals consider a decrease of that size a mere 'correction'. They don't even consider it a crash! And you don't have to go back that far to find a drop of that size. On October 9, 1987 the Dow closed at 2646. Two months later on December 11th it had lost 33% and closed at 1774. Will it happen again? Who knows. Can you guarantee that it won't happen again? I don't think so.
Sometimes we can learn from history. Between early 1948 and mid-1950 the stock market went up 47%. Just like today home sales were brisk. But, I don't think that people would have applied for this type of mortgage back then. The memories of families losing their homes during the depression was still too real. Instead of taking a risky mortgage people chose to buy a smaller home. Today, the generation that survived the depression are no longer applying for new home mortgages.
Should Bryan consider an asset-integrated mortgage? Sure! He should take a good look at anything that's available to him. If he's low on cash and has stocks that have gone up a lot, this could be a good way to delay paying taxes on the gains. But, before Bryan signs any mortgage, he should consider what could happen under any possible economic situation and make sure that he's prepared to handle it. Hopefully, Bryan will find a mortgage that fits his needs and he'll enjoy that new home.
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Gary Foreman is a former financial planner and purchasing manager who currently edits The Dollar Stretcher.com website and newsletters. You can also follow Gary on Twitter or on his blog.
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