Losing Property Value with Highly Leveraged Properties

(This was originally published March 18th, 2006. I've added a couple updates, but otherwise it's as published. It's still very relevant, and if there's anyone that wants to tell me I didn't nail it, please speak up)

Somebody wrote a comment about going upside-down on their mortgage:

What happens if the property value falls and becomes far less than the loan ammount? (POP) Lets say you get a loan for $280,000 on a home that was $330,00 and then three years later is is only worth $150,000, but you still owe $250,000 on it?

Now "upside-down" in the context of a mortgage is just slang for owing more than the property is theoretically worth. This is a tough situation to be in, and there's not much that can be done while you're in it except get through it. Before, yes. After, yes. During, no.

I've predicted that this is going to be a widespread phenomenon over the next few years, and it's going to cause a world of hurt, but it doesn't need to include YOU, unless this has already happened, and I thought Sandy Eggo, where I live, to be on the bleeding edge of bubble problems, and appraisers are still able to justify near peak values even here.

Surviving being upside down is actually pretty easy if you have the correct loan. I bought near the peak of the last cycle, and was upside down myself for little while. If you take nothing else away from this article, understand that the only time your current home value is important is when you sell or when you refinance. If you don't need to either sell or refinance, it does not matter what the value of your home is. It could be twenty-nine cents. It's still a good place to live. You've still got the loan you always did. You should be able to keep on keeping on until the situation corrects. Prices will come back sooner or later.

The key is to have a sustainable loan. I did. I had a five year fixed period, during which time the market recovered and I paid down my loan. By the time I went to refinance, five years later, things were better.

This is the real sin of the local real estate and mortgage industry. Yeah, the bubble's going to pop, and everybody knows it. Actually, it's already had significant price deflation. But if they had been putting folks into longer term sustainable loans, they'd be fine. Instead we've had about forty percent of purchase money loans being negative amortization and another forty percent being two year fixed interest only loans. The period of low payments for the former, and the fixed, interest only periods for the latter, are going to expire while prices are still down. That would be tolerable if the people could make the new payment, but if they could have made the new payment, they would have been in longer term fixed rate fully amortizing loans in the first place. What's going to happen next is kind of like when Wile E. Coyote looks down.

I've been telling people there are no magic solutions to the problem for over three years now. If you borrow the money, you're going to have to pay it back. Make the payments now or make them later, and the later it gets the worse it will be. There is no such thing as free lunch, and those who pretend that there is are not your friends. The Universe knows how much more money I could have made by keeping my mouth shut and screwing the customer. $200,000 is a conservative estimate. Instead of struggling to convince people to do the smart thing these last eighteen months, I could have been glad-handing everyone in sight and making a mint off of ignorant people. But then there would be court dates looming in my future (those in my profession who were not so careful are going to be in for a hard time, and I hope you'll forgive my schadenfreude when it happens. Those con artists masquerading as professionals stole a lot of money from me and from the people who became their clients by convincing them they could afford more house than they could, or by not admitting to the tremendous downside of what they were offering the client. "No, he just wants you to do business with him and he can't do what I'm doing." I could have gotten the loans, as I informed more than one of the clients I lost, and on better terms, but I wanted them to know the downsides. So I lost the business to the con artist who pretended there wasn't one. There were downsides, but people want to believe the con artist).

What to do if it has become obvious you're headed for the canyon? Figure out what your payment is going to do for the next several years. Determine if you're going to be able to make that payment before it happens to you. If not, refinance now if you can, sell if you can't. Pay the prepayment penalty if you have to, because given a choice between a prepayment penalty and foreclosure, the former is much better.

If you want to refinance, find a long term fixed rate loan. Minimum of five years fixed, fully amortized. Since thirty year fixed rate loans are actually about the same rate as 5/1 ARMS right now, I've been recommending the thirty year fixed for almost everyone. This is a loan that never changes, and you never have to refinance because the payment is going to jump.

(UPDATE: 5/1s are now significantly cheaper than thirty year fixed rate loans again)

The critical factor for refinancing is the appraisal. The critical factor for the appraisal is how much value can be justified by the appraiser. In order to justify the value, there have to be comparable recent sales (not more than one year old) in your neighborhood. The appraisers don't always have to choose the most recent; they have the option of choosing better matches for your home. May the universe help you if there are model matches selling for less in your condominium complex, because there the lender is going to insist on the most recent sales. All the more reason to act now, while you can, rather than wait and hope.

(UPDATE: With Home Valuation Code of Conduct the appraisal has become the source of more problems than any other aspect of a real estate or mortgage transaction)

If you're already over the chasm and prices have fallen, consult some local agents about selling. Short payoffs are no fun, but in the vast majority of cases, they're better than foreclosure if you're not going to be able to make your payments. At least when they're done, they're done. Foreclosure is a hole that keeps on draining you long after you've lost the house, and after it's cost you thousands of dollars more than a short sale (and if sale prices continue down, that 1099 love note from the lender after the foreclosure is going to be worse). As for waiting, well, if it's an honest consensus that things are coming right back, but here in San Diego the Association of Realtors had not yet admitted there's price deflation despite it going on for almost a full year. They've been playing games with reported figures to make it seem like things are rosy. There are obvious motivations for this, not all of which are explained by self-interested greed, but it's not something you can paper over and ignore indefinitely.

Who's to blame for the impending train wreck? I'm not really into blame, but here are several targets. Unscrupulous lenders and agents bear a lot of blame, but not the exclusive burden. Panic and greed on behalf of the buyers is certainly a significant part. And if several folks are telling you that the best loan they have is five and a half or six percent or even six and a half, shouldn't a normal, rational adult be suspicious of an offer that's theoretically at one percent? I can maybe believe somebody who offers something a quarter of a percent better than the competition. Half a percent might be just barely possible at the same price. Somebody who offers money, of all things, that's less expensive by an interest rate factor of five isn't telling you the whole truth. (Unfortunately, in this case, these loans are so easy to sell on the basis of minimum payment and nominal rate, it got to the point where these loans were what the vast majority of agents and loan officers were talking about)

As a final note, 125% loans do exist (UPDATE: Not really, anymore, but for a while, there was a 125% refi in place program enacted by Fannie and Freddie, if your loan was backed by them), but they are ugly. Very ugly. Not as ugly as Negative Amortization, but ugly, and the payments and interest rates aren't any more stable than the real terms on those Negative Amortization loans. They don't do stated income, either, or non-recourse loans. You stiff those folks, they will get the money out of you.

Prices are going to come back up. It's as predictable as the fact that they were going to fall. Can't tell you when, anymore than I could tell you when exactly they would start falling. (UPDATE: Housing recovery is ready to happen, whenever the government pulls it's head out of where it is right now) Doesn't mean it won't happen. The trick is to have a sustainable situation in the meantime, and this means a loan with payments you can make every month, month after month, indefinitely until the loan is paid off or you have the ability to refinance or sell. If you've got this, someday you'll be telling yourself how happy you are that you bought that property. If you don't have it, get it. If you can't get it, get out.

Caveat Emptor

(I originally published this March 18, 2006, but most of it is still highly relevant.)