There are many misconceptions in the mortgage universe, but perhaps none are potentially as dangerous or as costly as this particular mistake. My clients are often caught off guard and I wanted to share this with a larger audience in the hope that it will help someone.
The title of this post captures the issue - the myth of the equity rich home. I have talked to numerous clients who's goal was to pay off their mortgage as fast as possible. (In and of itself, there is absolutely nothing wrong with this goal, though some strategies are significantly better than others.) Some were making one extra payment each year while others were doubling up their payment each month. Their logic was that if anything ever happened, they would have an extra cushion because they didn't owe much on their mortgage in comparison to the value of their home. This couldn't be further from the truth!
This assumption can trace it's roots back to the Depression era in our country. Once upon a time, almost all mortgages were callable. When the stock market crashed in 1929, there was a chain reaction of events that caused an eventual run on the banks (think George Bailey and the Bedford Falls Savings and Loan). The bank's only option to meet the demand of the withdrawals was to call in the mortgages they held. These were generally the same people making the withdrawals, and didn't have the money to pay. We all know how ugly things got as the rest of the Great Depression unfolded. Some of the people that were least affected by all of this were the people that owned their home free and clear.
Things are very different now. Mortgages are NOT callable. Also, your mortgage is most likely not with the bank down the street but rather with a mega-servicer. Many people aren't aware of the fact that frequently the mortgage servicer does not own the mortgage. (For an ultra-detailed behind the scene look at servicing, please see this site). This can cause some challenges in the event someone is late on their mortgage or falls into some type of hardship.
The job of a servicer is just that, to process payments and in the event of a non-payment, take the necessary steps. They have some authority to make arrangements depending on a person's individual situation, but often they just follow orders from the investor that actually owns the mortgage. If suitable arrangements can't be made, the next step is foreclosure.
This brings me to my point. The more equity you have in your property, the more likely the investor will foreclose on your home and foreclose quickly. Think about it from the investors standpoint - you have two loans that aren't performing. Loan #1 is for $250,000 and loan #2 is for $190,000. The difference? House #1 is worth $500,000 and house #2 is worth $200,000. The investor knows with virtual certainty that it will be made whole on house #1 if it forecloses. House #2 is a much bigger risk as there is a much greater chance of suffering a loss. Thus the investor will be much more likely to work out an arrangement (reduced interest rate, forbearance agreement, etc) in order to try to save the situation and avoid foreclosure.
I share this story frequently with clients not scare them (hopefully) but to get them to think about alternatives. One option I share frequently is the idea of paying off your mortgage on your own personal balance sheet. Instead of sending that extra payment to your mortgage servicer, send it to your financial planner. Besides the fact that your money is very likely to grow faster than the cost of your mortgage (over the long run), you have the security of having the funds under your control. If you ever have an issue, you have a large reserve to see you through the hardship instead of parked in your house where it can't help you.
In closing, I wanted to mention that much of what I share is a generalization. Each situation will be different and the information I share may not apply to you for a variety of reasons. Stereotyping is never good (unless you are trying to sell t-shirts for The Onion) and I want to make sure I don't throw everyone into the same bucket.
If you are facing a hardship please feel free to contact me. I am happy to help, even if it's just sharing some advice with you.
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