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The Credit Crisis: How Some People Won

The opinions expressed by columnists are their own and do not necessarily represent the views of

Not everyone who owns a house or has bought one lately has lost it, nor have very many realized real financial losses. There are certainly a lot of paper losses, more than we need or should have had, but I believe most people will get through the mess okay. Some will actually be big winners and those are the ones I wish to highlight. What is their secret, how did they figure it out, and how can you be just like them? It starts with understanding what you are doing when you are buying a house: how to take advantage of the opportunities given to you, and how to avoid the common mistakes. And so we begin a somewhat historical visit to the housing and finance markets while we are still in the middle of the credit crunch. Paraphrasing a famous quote, “If you study what happened and understand it you won’t be subject to repeating the same mistakes!”

The key to success is low interest rates—pretty simple stuff that most people can understand. How you use the low interest rates amounts to taking the key and opening the door to your future. Those who took the interest rates and put them to their highest and best use are the winners. Those who either didn’t react or took the opportunity and squandered it were the losers. The following is the hierarchy of the highest and best use:

1. Investing for your future, externally or internally.

2. Securing a long-term, low-cost future.

3. Securing a short-term, low-cost future

*10. Trying to use short-term tools for long-term success.

If you are wondering what happened to 4-9, I simply skipped to number 10 to show how far away this strategy is from successful ones. It is obvious that most who are in trouble today were advocates of number 10. Now let’s take a hard look at each of the ideas and see why I ranked them in that order.

Investing for the future via your house can take two forms, and both have merits:

* Taking a shorter term loan as a 10-year or 15-year fixed, or;

* Pulling out money for other investments with a longer-term, lower interest rate loan, knowing that the return you will be making on your invested funds will exceed what you pay on the loan

I like the first way because it is guaranteed: you make your payments for 10 or 15 years and you own your house, free and clear. The second part of that equation is that when your house is paid off, the monthly cash flow that would have gone to the house payment is available for other investments. For the last five years, we have had the 10-year and 15-year in the 4% range for a part of each of those years. It was always there for conforming loans and a good part of the time for jumbos as well. Those who took advantage of these rates are smiling through the credit demise that is shaking this country. Their house may have gone down in value, probably temporarily, but their equity isn’t being destroyed as quickly as those who are sitting with higher, longer term rates. Eventually most of it will return as the house gets paid off, even if the value doesn’t come all the way back.

The second form is riskier from my point of view but maybe not from yours. You may be in an investment, business, or group that is doing well and welcomes more capital to continue the growth. I can’t tell you whether it is a good risk or not, but if you are comfortable with the scenario, then borrowing from your house at historically low interest rates may be the answer to your financial future. Remember, gambling and speculating are not the same as investing and if you don’t understand the nuances, you are risking both your money and your house.

Securing a long-term, low-cost future is the next best thing you can do with low interest rates. The way to do this is with a long-term, 25 or 30-year loan at rates from the high 4% range to the low 5% range. This will take you right through the credit crunch without a care in the world because you have a fixed rate that is manageable now and in the future. The problem with this approach, and what moved most borrowers into the third strategy, is their failure to plan for the future. When rates came down, everyone raced to refinance and lock in a low, long-term rate. Few took the time to consider future needs.

The easy solution was a low interest HELOC, home equity line of credit. After all, they were also in the 4% range. The difference was that they were a variable and as interest rates went up so did the interest and the payment. Not to worry; there were also low-interest credit cards to take care of the problems that came forth. In the short run that worked; in the long run, the cards’ interest rates also went up. Now the dilemma: borrowers had great low-interest first mortgages but higher and higher debt being financed by HELOCs and credit cards. They were reluctant to give up their 4% and low 5% mortgages even though their blended interest rate was in the 6% or 7% range. (Blended rate is the total of all debt divided into the total interest you paid on this debt.) Eventually they were forced to see the light and give up their long-term, low-interest rate for one that was less than their blended rate. This meant they had a short-term, low-cost experience, not a long-term one.

To avoid that ever happening again, you must anticipate your needs and set up reserves. (Reserves are monies set aside for future expenditures that were not apparent at the time you took the money out of your house.) At this point, you are may be worried that if you pull out the money out of your house and it goes down in value, you would owe more than it is worth. My belief is that if you don’t pull out the money and your house went down to a point that at best you are even, that you wouldn’t have the money when you need it. Reserves buy you time for corrections in the market and in your own financial situation. Without them, you are at risk.

And now for the infamous number 10: taking low, short-term interest rates and expanding your standard of living based on these payments. Who would do something like that? For starters all the people who took the 1% option ARM and are now saying they didn’t understand it. I am not making any comment except that those who made the mistake are much wiser, if not poorer, at this point. The idea is to never look at that type of strategy again. Also realize that it wasn’t the loan that was the problem but how you used it. I have had several clients who have used the option ARM and made it work. Its best application is by borrowers who use their money to make money and therefore need the lowest possible payment all year long. At the end of the year, they write a check for the deferred interest and the increased loan balance goes right back to where it began the year, without a trace of negative amortization. The reason: they end up paying all the interest on the loan so nothing is added to the balance for the long term. That takes discipline and sufficient good fortune on investments.

Others who can use the option ARM successfully: those with over $1 million of equity in their houses and limited income. They use the negative amortization (the amount of interest being added to the loan balance that wasn’t being paid) as a form of reserves. It is their way of drawing money out of the house for their use. Not my favorite way of getting reserves, but in their cases it can work for a number of years.

The simple answer to winning is planning your future, taking advantage of the market place, and most of all seizing the opportunities that are presented. Those who did won; those who didn’t…well they know what happened. The bottom line is that we can all learn today and prosper in the future.

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