Is It Time to Refinance?

A financially savvy CPA I know bought a spectacular house three years ago--more house than he should have been able to afford on his salary. He took out an interest-only loan and said he'd eventually refinance. The market value of his home danced higher, and before long he leveraged that, too, tapping a home equity line to invest in an undeveloped lot. Welcome to the era of fully leveraged homeownership. Everybody's doin' it.

The low interest rates and high home-price appreciation during recent years have allowed millions of Americans to borrow tens of billions of dollars in home equity debt. The tide, though, has turned: Interest rates are rising, and home prices are flat or falling in many parts of the country. What now for homeowners like my friend the CPA, who borrowed heavily against the roof over his head?

There are real risks. The biggest is that you'll end up underwater on your home loan. This seems far-fetched, following a time when home prices jumped as much as 20 percent a year, but it wasn't long ago that homeowners in Southern California and elsewhere simply walked away from homes they couldn't afford and couldn't sell for enough to cover the debt. Similar stories will be heard sporadically this year from once-hot housing markets. For people who borrowed much or all of their home's value and soaked up appreciation with home equity loans or lines of credit, it won't take much of a downturn to end up in the red.

As long as you don't sell the homestead, you can probably ride out any real estate storm. But if you have to refinance that interest-only loan at a higher rate, or if circumstances force you to sell, the house of cards could come down. Another problem: Home equity lines are typically interest-only loans, so making minimum payments won't make a dent in the principal. And woe to the homeowner who jumps from loan to loan in search of better terms-most banks charge an early termination fee. These and other factors conspire to keep you in debt, and in an era of slower home-price appre-ciation, that debt may be more of a burden than you anticipated.

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This article was originally published in the May 2006 print edition of Entrepreneur with the headline: Playing House.