Getting Real About Real Estate

Last year the question was whether the housing boom would slow down. Now it’s how bad it will get. Navigating the market is more challenging than ever.

By Ellen Florian Kratz

January 30, 2007

[continued, page 3]

Here’s an example. Suppose a homebuyer obtains a $350,000 mortgage today using a 5/1 interest-only ARM at 6.25%. That means the borrower pays just interest for the first five years at the guaranteed 6.25%, after which the principal kicks in and the interest rate becomes adjustable. The beginning payment is $1,822.91 per month. So what happens five years from now when the loan converts from interest only to interest and principal, and the rate faces its first adjustment? FORTUNE asked Greg McBride of Bankrate.com to calculate various scenarios. Best case: If the rate falls to 4.25%, the payment would still rise to $1,896.08 as the principal starts to amortize. If the rate stays at 6.25%, the payment rises to $2,308.84. If the rate were to jump to 8.25%—which is entirely plausible—the payment would hit $2,759.58. That’s not necessarily the end of it: The borrower could still face further rate increases in subsequent years. “Make sure you can afford the fully amortized payment,” says Zelman.

Pat Davis-Lemessy, 44, of Miami Lakes, Fla., knows firsthand how painful these sorts of home loans can be. In 2003, when she purchased her 1,700-square-foot home just minutes away from where she works as a medical plastics engineer for a subsidiary of Johnson & Johnson, she signed up for an interest-only loan with a 3.4% teaser for the first four months. At $850 a month, the teaser was easily affordable. But then her payments started creeping up by almost $200 each month until she found herself paying $1,770—in interest only! Last year she did the smart thing and refinanced into a 30-year fixed at 5.25%. Doing so cost her $5,000 in fees, but she considers that well worth the peace of mind of knowing exactly what she’s going to owe each month. “If I’d done a fixed rate when I bought, it would have been 4.65%,” she says. “The adjustable rate was a mistake. I lost thousands in equity on my home.”

Shop for a Rate Drop

When Tom Downie and Rebecca Romajas first laid eyes on their 18th-century Connecticut colonial, they knew they had to have this historical gem. It had rough edges, so soon after purchasing it in 1999, they got to work. Tom, 35, a public relations manager, laid a stone patio. Rebecca, 33, a senior technical director for AT&T, framed the unfinished windows in the sunroom. Soon they decided to tackle projects that went beyond the do-it-yourself level, so they borrowed $32,000 from a $60,000 line of credit and called in the pros to do something about their Brady Bunch-era kitchen. The terms of the deal: They were required to pay the interest only on a variable monthly rate of prime plus 0.99%. Rates were low at the time, but to be safe, they chipped away at the principal. (Tom and Rebecca have always been cautious when it comes to debt. As exotic mortgages were proliferating, they stuck with a 30-year fixed loan, which they refinanced in 2003 to a 15-year fixed.) Four years later the loan amount is down to $23,000.

During that time the Fed raised short-term rates 17 times, and the Downies’ monthly interest payments have risen along with those hikes (last month their rate was 9.24%). To get the most for their money they’ve decided to roll their line of credit into a fixed-rate loan. But before accepting their bank’s kind offer of 8.5% on a five-year fixed, they’re shopping around. “I’ll get four or five offers,” says Rebecca. “I’ll write them all out in a notebook and compare each one.”

The Downies couldn’t have chosen a better time to look for money. In 2003 the mortgage industry originated $3.8 trillion worth of loans, according to the Mortgage Bankers Association. Next year it will hand out an estimated $2.1 trillion. “That’s nearly a 50% drop in volume, which means there’s tremendous pressure on company earnings,” says Doug Duncan, chief economist with the MBA. “They’re going to negotiate to get your business.” Bank of America offered the Downies the same loan for 8% with no fees. Webster offered 7.44% with $230 in fees. And TD Banknorth’s rate is 6.49%, as long as the payments are deducted automatically from their checking account.

Keep an Eye on Your Equity

The Downies borrowed against their growing home equity to improve their home, but not everyone has been so wise. Of the nearly $2.8 trillion that Americans have withdrawn from their homes in the past five years, plenty has gone toward such farsighted capital improvements as trips to Disney World, fancy clothes, boats, etc. The good news, of course, is that reckless spending has kept the American economy chugging. But it has also saddled many American families with some major debt, which is particularly dangerous in a declining real estate market.

Bottom line: Lay off the home leverage, because if you run into trouble, the price appreciation won’t be there to bail you out. According to the forecast, only four of the 100 metro areas are expected to grow by more than 5% next year. That’s a big comedown from the frothy 20%, 15%, or even 10% annual increases that you’ve been conditioned to expect as normal. One more piece of advice on the equity front: Go easy on remodeling projects. When housing appreciation was through the roof, a $100,000 state-of-the-art kitchen probably paid dividends if the home went up for sale. Today that’s no longer the case, so you need to think hard before shoveling a lot of extra money into your abode. Spiffing up in order to go to market is one thing; ripping up the entire first floor to improve the layout is another. “If you’re trying to determine whether a home improvement is a good investment, it’s probably measurably less so than it was,” says Zandi. As careful as the Downies have been with their equity, they also have dreams of making their home utterly fabulous. One amenity they’ve always wanted: an outbuilding for holding summer parties, which would cost $30,000 to build. Considering the current real estate market, those plans, utterly fabulous though they may be, are on hold indefinitely.

It’s a new market. And as far as sensible homeowners like the Downies are concerned? Solvent is the new fabulous.

1 | 2 | 3 <Previous Page