Saturday, November 7, 2009

A reply to a users comment regarding underwater homeowners

Comment from reader Richie regarding underwater homeowners: “When you buy a house, even at peak prices, chances are good that you will be able to sell that house for the same price (or more) than you paid for it - at some point during the 30-year mortgage.

There was a day when you looked at that house and decided you can afford it and it was a fair price. You signed contracts in relation to that. So as long as you can continue to afford to pay for it, I don't see why you should ever quit paying.”

I think people signed for a price based on all sorts of optimistic assumptions based on not understanding that they were in the midst of the final culmination of the greatest credit bubble in human history. This isn't hyperbole, this is the facts of the case as it stands now. The homeowners were making poor decisions.

Here would be a simple example. Let us say you saw the tremendous appreciation of the boom and were counting on that appreciation to replace your savings. In other words you were putting money into your house payment instead of your savings account. This is not radical thinking during the boom time but instead an emotional rationalization to overspending for a home that you desire. The last boom locally in the San Fernando Valley it took 11 years for median prices to recover... This boom was much much bigger.

In fact people took it much further, especially in places like California. The loans they took out were ARMs, during a period of extremely low interest rates. Or they were interest only, no amortization so you aren’t paying off any of the loan balance. Or the loan had a negative amortization feature, paying less than interest owed. These “subprime” loans are aptly named (Note, many banks wouldn’t consider the loan features subprime but based the classification subprime on the borrowers FICO score my subprime classification is of the features of the loan), the loan is less than ideal and designed to maximize what the borrower pays in total cost for the home. So people may be able to pay the payment today but realize they are just renting the home from the bank until such time they are no longer underwater which is now some indeterminate time in the future.

So the boom time appreciation no longer applies and in fact the boom time borrower has seen significant depreciation. Many put little into the home for a down payment, aren’t paying down the loan balance, have little to no savings, and are significantly overpaying every month for what the house rents for (and always were). They CAN continue to pay… but is it in their best economic interest TO keep on paying?

Once you realize you have made a mistake do you continue doing the same thing or do you try and fix it? What would be the best fix for people in this situation? I think many aren’t even at the point of realizing they have a problem, they didn’t have much in the bank before they bought and still don’t have much in the bank now. Barring an epiphany, only life events will jar them from their rut. But if they do have the epiphany and look at the math, realize the house isn’t doing the saving for them. Something will need to be done.

We can also apply this to various underwater borrowers, not just those without assets or put no money down. Those that weren’t building a nest egg have a choice of overpaying for a home or trying to build reserves. For those with significant assets and still significantly underwater it becomes more of a mathematical exercise, while they will be able to continue to pay it may mean a significantly diminished nest egg in the future. This is a result of them overpaying for the asset every month. Their nest egg may have also been hit during the market downturn and they realize they have fixed their costs higher than their assets will allow for long term financial stability.

1 comment:

Richie said...

When I posted that comment it was more in regards to the morality of walking away from a mortgage that one can still afford to pay on.

I am not really even arguing one way or the other. I am very undecided of the morality involved.

I definitely think it is in the best financial interest for a lot of people to walk away from their underwater houses.

I also think it is in my best financial interest (as somebody who hopes to purchase his first home some day) for these people to walk away from their underwater houses and flood the market so it returns to rental parity or below.

Where it should be.