A few years ago, a friend of mine quit his job at a bank to focus on his own company. That can be a risky life change by itself, but in addition to his change in income, he and his wife were expanding their family. While I’m sure they would have been fine remaining in their apartment for a few additional years to ensure the new business could provide income, they wanted to purchase a house right away.
The mortgage broker they were talking to must have been very good. When they signed the paperwork for the adjustable rate mortgage, they were paying less per month (not including insurance and taxes) than the cost of rent in their old apartment. The premise could be valid. An adjustable rate mortgage allows you to qualify for a lower rate now while you’re earning less. Despite many studies that have recently declared that real income has been steady or has decreased for most workers over the past decade after taking inflation into account, most people have an impression that they can handle the increase in mortgage cost later because they’ll be earning more money.
For this particular friend, the decision to go with an adjustable rate mortgage paid off. His business found success early and he did not have a problem when the interest rate recently jumped. The situation could have easily gone the other way; in fact, it almost did. He managed to sign a major client at the right time, and it moved his business into profitability. Without the one client, his finances would have been in trouble.
Another friend of mine, when buying his second house, considered an interest-only mortgage. This is another good option to increase cash flow in the short term, but it means larger expenses later on. Unlike adjustable rate mortgages, if you’re paying only interest, you’re not building any equity in your home. In the beginning of mortgage repayment, building equity would be slow, anyway, but it’s helpful to start paying down the principal as soon as possible.
In the days of the runaway real estate market, homeowners could increase their equity just by watching the value of their home increase, but there are few locations where that strategy would work.
Along these same lines, homeowners would often take advantage of double-digit increases in value by refinancing their mortgage and walking away with cash. Enterprising individuals often find this cash helpful for making improvements to their home — and these improvements only pay off in terms of enjoyment of the living space, not future resale value — or investing in their own business.
Adjustable-rate mortgages, interest-only mortgages, and cash-out refinancing aren’t always mistakes. These could be the right options for many people, and several years down the road, one could look back and determine each one was, for any particular person, the best choice. These techniques often probe to be financially devastating if the housing market crashes, your income doesn’t increase as expected, or your business fails.
When plans don’t work out and the mortgage becomes too tough to handle, a family could find itself facing foreclosure.
Published or updated June 13, 2011.