Protect Yourself If The Bubble Bursts

How To Handle Your Mortgage In A Real Estate Slump

(CBS)  With interest rates on the rise, and the housing market showing signs of a downturn, homeowners are starting to feel the squeeze.

For many, the trouble started when the market was booming, and buyers flocked to interest-only loans in order to find their way into a bigger home. These interest-only loans were an attractive option while rates were low, but once the fixed term ends, monthly payments are likely to jump up to twice the previous amount.

In the worst case scenario, homeowners could end up owing more money than their home is worth. The Early Show co-anchor Harry Smith had the story of one family that is caught in the squeeze.

Meghan and Vince Jordan recently moved in to their brand new dream home in Denver, but they have one big problem — they can't get rid of their old one.

"A year ago, we don't think we would have been in this situation. We think our house probably would have sold," said Meghan Jordan.

Their home has been on the market since August, and so far they have dropped the price by $35,000. Now, the Jordans have taken a bridge loan to cover the costs of owning two homes. Even more nerve racking, they've taken out an interest-only loan, so for five years they are only paying interest. With rates on the rise, they are worried they took a bad risk.

"That is the $90,000 question — what if (rates) don't come down? You are going to see people with properties with rates that can potentially double," said Vince Jordan.

The Jordans are highly leveraged, they have two kids, two mortgages and daycare costs. And their quandary is not unusual. Greg McBride from Bankrate.com joined The Early Show Thursday to discuss ways for homeowners to protect their financial health.

First, a look at the risk that comes with an interest-only loan. If, for example, a borrower took an interest only loan of $200,000 in 2003, their monthly payment would have been around $667. After the first adjustment, those monthly payments could jump to $1,415 in 2006.

"That's why (interest-only loans) are right for some but wrong for a lot of people. That payment increase is not something the average American household can handle. That increase is a byproduct of two of things," McBride told Smith. "The initial interest rate of 4 percent when you borrowed the money now jumps to something over 7 percent. You also have to start paying back that principal. You could see another payment increase next year. After all, interest rates are still rising."

If you find yourself in this predicament, McBride says you should refinance out of harm's way.

"You can still get a 30-year fixed rate mortgage for less than 6 1/2 percent," he said. "Your payment is going to go up but not as much as if you hold onto that interest-only loan. The other thing is it's really a one-time hit because you are then looking at that payment for the life of the loan as opposed to the interest-only where you are a sitting duck for another increase next year."

McBride stresses the importance of cutting into the loan balance and starting to build up what he calls an equity cushion, something the Jordan family doesn't have.

"They were 100 percent leveraged," he said. "They don't have any wiggle room. They need to start chipping away at the loan balance, building up an equity," which is so important because "if you have to sell suddenly, that's what's going to absorb your transaction cost."

Another important piece of advice from McBride: don't borrow against home equity.

"If you are the type that's going to go out and run up additional credit card debt it's best to leave that home equity untouched," he said.

This means no home equity lines of credit to pay off credit card bills, no cash-out mortgage refinancing to pay for home improvements, and no tapping into home equity to pay for goodies like vacations. To do so would mean eroding your protection for when home prices decline.

"You can't bank on home appreciation to do your saving for you. It's time to put the noisemakers and punch bowl away because the party is over on that end," said McBride.

Finally, he recommends living in your home for the long haul. That means accepting the idea of your home as a long-term investment, not a vehicle to get rich quick. Treating it that way is an important form of protection against a bursting real estate bubble.