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You Can't Eat Your House: What Today's Troubled Borrowers Can Teach Us

Posted by  on Jun 03, 2010
 

Why would homeowners forgo paying their mortgages, which are secured loans, in favor of keeping their unsecured credit card accounts current? "This goes against conventional wisdom and that has always been that, when faced with a financial crisis, consumers will pay their secured obligations first, specifically their mortgages," said Sean Reardon, the author of the study and a consultant for TransUnion, in a recent interview with Reuters.

While 6.6% of those studied were current on their credit cards but late on their mortgages in the third quarter of 2009, only 3.6% of consumers were delinquent on their credit cards and current on their mortgages. But that's not all--of those with the lowest credit scores, nearly 30% of them opted to pay their credit cards over their mortgages.

Why Choose a Credit Card Over a Mortgage?

Home loans at today's mortgage rates are much cheaper financing than credit cards, which can carry interest rates at 30% or more. And credit card debt can be discharged in a bankruptcy, while mortgage debt cannot. But homeowners who are truly unable to manage their bills as a result of unemployment or other circumstances need to keep some sort of cash flow available--by making minimum payments on credit cards, they keep them open and available as a source of cash. These people are choosing their credit cards because they can't buy groceries with their houses.

What Does that Teach the Rest of Us About Refinancing Home Loans?

In the past, financial gurus often encouraged people to pay off their homes as quickly as possible. Refinancing to fifteen year terms was deemed a great investment if you could afford it--and you'd be rewarded with the lowest mortgage rates as well. And recently, homeowners have been chastised for "using their homes as ATMs" and cashing in their equity. But in rough economies, cash out of the home may be more useful than cash locked up in home equity.

Build Up Emergency Funds Before Prepaying Mortgage

Financial planners now say that building a healthy emergency fund--between six and none months of expenses--is more important than amassing home equity. Then, fully fund your retirement--the money does get tied up, but it's easier to borrow against than real estate in today's lending environment. Finally, if you foresee the possibility of financial difficulty, tap home equity of you can with either a cash-out refinance (FHA lets you borrow up to 85% of your home's value) or a home equity loan. Do it now, because banks prefer to lend you money when you don't need it.

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