Dealing with dropping home equity

In less than a year, the world of homeowner lending has been turned upside down and, going forward, it’s going to be much harder for clients to obtain new lending arrangements. Adding to this problem is that a key piece of collateral many Canadians use — home equity — is declining in value.

"If you’re living in your house and making your mortgage payments, at the end of the day the value will come up. It’s just the circle of equity," says Jeff Mayer, a Toronto-based mortgage broker with Mortgage Intelligence. "If somebody has borrowed a down payment on their first house, leveraged everything and did that based on the fact they are going to be able to refinance down the road to pay out the debt, that’s not going to happen. Those people are going to lose their home if they can’t maintain the debt. It’s a harsh reality — but it’s the truth."

Mayer points out that this type of situation is not nearly as common here as it is in the United States, but he says there are a number of Canadian homeowners who borrowed from U.S. lending companies who are going to find themselves in trouble when it comes to refinancing.

"These companies were doing things like 90% financing with clients who had blips in their credit. They didn’t really fit into the Standard A banks. Those mortgages will be coming up for renewal and there is nowhere to place those in today’s market," he says. "We’re going to see a lot of power of sales going forward."

He says buying or refinancing a home is also proving to be trickier in this environment. For example, he says lenders want appraisals done on a home’s value by looking at the sales of three comparable properties that sold in the last 90 days.

"They can’t find comparables, because nothing is selling," Mayer says. "If you talk to appraisal companies used to appraising on the upswing, now they’re appraising on the downswing because the market is coming down. They don’t want to be found liable for anything, so of course they are coming in low."

This has a knock-on effect when it comes to refinancing home debt — a process that itself has become more difficult, Mayer highlights.

"I personally don’t think it’s time to refinance, but maybe it’s a good time to check what the value of your property is. Talk to a broker, check what the situation is with regards to your location and the value of your house. Right now, Municipal Property Assessment Corporation can assess you pretty close to what the market value is," he says.

"If a client does need to go back to a lender, they need to realize the bank is going to reassess many details," he continues. "Eight months ago, all you needed was a pay stub. Now you need that, plus a T4 and a job letter. They are going to verify all those items with the company you work for, in addition to doing a 411 and Google search to make sure that the company exists."

The tougher lending requirements and uncertainty in real estate are key reasons for clients to try to get as much debt off their personal balance sheet as possible, says Scott Plaskett, a CFP and CEO of IRONSHIELD Financial Planning.

"Given the situation in the economy right now, it’s critical you don’t miss payments. You should continue with at least your minimum monthly payments. With interest rates so low, it’s probably in the client’s interest to actually increase those payments, thereby eating the principal as quickly as you can," he says.

Plaskett doesn’t have much trouble convincing clients to continue home payments even as the value of their home decreases.

"We haven’t had any clients who really see their house as an investment. For most clients it’s their home first of all. Ideally, it would nice for the investment to rise in value over the duration of time they are paying off their mortgage. That doesn’t always happen," he says. "Planning for a downturn is all about building equity in your home and getting it paid down as quickly as you can."

Plaskett says clients should consider turning their traditional mortgage lending arrangement into a home equity line of credit — assuming they qualify for one. Generally these used to be offered at prime rate. Plaskett says he’s not seeing that anymore; however, with rates at historical lows, they still remain a compelling option.

"Any time a client can qualify to replace their mortgage with a secured line of credit, we’ve recommended they do so. As a planning tool, we’ve recommended that even if you don’t need the credit, get it anyway. There’s a likelihood one day you will need it, and when you do, you probably won’t be able to get it," he says. "Maintaining a line of credit doesn’t require anything beyond interest-only payments. If you come to a point where something happens that was unforeseen that put you into a cash crunch, the only requirement is the minimum interest payment."

Clients shouldn’t rule out a debt-flip strategy if it works for their personal financial arrangement, Plaskett notes.

For example, if he has a client with $100,000 in a non-registered account, he might suggest the client use that $100,000 to pay off the mortgage, re-borrow it back against the house and invest it. Now the interest payments are tax-deductible, and the client is still invested in the market.

"The recent Lipson Supreme Court decision has reinforced this as a solid planning strategy," he says. "The client ends up with a tax-deductible mortgage. If there’s any need for cash, they’re once again only obligated to make that minimum interest-only payment."

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(02/10/09)