At last count, an estimated 10.7 million residential mortgages — almost a quarter of all home loans in the U.S. — were underwater, meaning that the property was worth less than the amount outstanding on the mortgage. This is a legacy of the housing and credit bubbles: with every underwater mortgage, a potential default and foreclosure.
As the number of such mortgages has grown, more and more borrowers have simply decided to walk away. That seemingly reckless move is now not only tolerated but encouraged — even among those who can afford to make the payments. I’ve recently read articles in the mainstream media suggesting borrowers will come out ahead if they stop making payments on underwater loans. But does this make sense from a purely economic point of view?
Let’s dismiss for the moment any legal or moral reasons to keep making payments on a house whose value has fallen. I admit that I was raised to believe that willingly defaulting on a mortgage woul be unthinkable. Of course, much the same could be said of divorce. Both are now commonplace. But there are some practical consequences to default, including a damaged credit rating and inability to get another mortgage for several years.
From a short-term perspective, the case for default seems obvious. Why keep making payments on an asset that is worth less than the debt it carries? One of the peculiarities of our mortgage finance system, when you stop and think about it, is how much leverage is built into the market for housing. People who wouldn’t dream of borrowing money to buy stocks on margin, considering it too risky, have no trouble piling on leverage when it comes to their home, borrowing 90 percent or even 100 percent of the purchase price. Of course, real estate is expensive — few purchasers have that much cash — and housing prices are less volatile than stocks. Still, real estate is an asset like any other. Values go down as well as up. And leverage always magnifies losses as well as gains.
Let’s consider a hypothetical house that sold for $500,000 at the top of the market in 2006, purchased with a 10 percent down payment and a $450,000 mortgage. Assuming a 25 percent drop in value since then, the house is now worth $375,000. If the owner stops making payments and abandons it, he loses the down payment of $50,000 plus all subsequent payments of interest and principal. That’s a total loss.
Bad as that outcome appears to be, the alternative seems to be to throw good money after bad. Default at least caps the loss at the down payment plus payments already made. If this was a typical 30-year mortgage, 26 years of payments of interest and principal would remain on an asset now worth just 83 percent of the original mortgage. And assuming the borrower has the resources to pay off the mortgage in full and then sell, he would lose $125,000 on the investment, plus interest he’s paid — more than double the cost of simply defaulting and walking away. Moreover, he can probably rent something as nice or better for less than the equivalent monthly payment and live happily ever after. This, in a simplified nutshell, is the case for default.
But I’m not convinced the case is nearly so simple. The analyses I’ve seen in support of walking away assume a static housing market, in which home values are fixed at their current low prices. But historically, housing prices have consistently risen over time, and it’s quite possible that real estate prices hit their ultimate lows around August of last year.
To walk away from an underwater mortgage now is the equivalent of selling at what may turn out to be the bottom, or close to the bottom. Just as with stocks, the Common Sense strategy is to buy lower and sell higher, and even if this doesn’t turn out to be the bottom of the real estate market, we know for a certainty that it’s not the top.
Let’s assume that housing prices continue to recover and revert to a modest average rate of appreciation — say, 5 percent a year. At that rate, our hypothetical home will be worth $1.3 million in 26 years, when the mortgage is paid off. That’s nearly three times the purchase price. Of course, this homeowner might not want to wait that long. Still, at 10 years, the value would be $610,835, which represents a decent gain. After six years, he’d be back at break-even. To me, that doesn’t seem all that long to wait as an alternative to realizing a loss of over $50,000 by abandoning the house now. And remember, I’m using conservative numbers: The National Association of Realtors says the historical annual gain is 6 percent.
There’s also the opportunity cost of defaulting when real estate prices are low and likely to increase. By the time defaulting borrowers restore their credit ratings to the point where they’d be eligible for another mortgage, they will have missed years of housing-price appreciation. And the attractive rents currently available as an alternative to mortgage payments are unlikely to last once markets recover and landlords can raise them.
To be sure, everyone’s circumstances are different, and all housing markets are local. But after the recent plunge in prices, a reversion to historic norms strikes me as a reasonable possibility. Having lived in the same house since I purchased it 10 years ago and putting 20% down, I’ve never experienced an underwater mortgage. But I had friends who bought a home in Baltimore County in 1990, just in time to see its value drop by about a third during the recession of 1991-92.
They lamented this turn of events, saying they felt trapped in a home they couldn’t sell for the amount of their mortgage. But they stayed, made their payments, and nearly 20 years later, their home is worth far more than they bought it for. And with their credit rating intact, they were subsequently able to get a mortgage on a house in the country. The years they were underwater now seem inconsequential.
At the very least, the case for staying with a mortgage seems to me far more compelling than might first be apparent. And fulfilling an obligation also strikes me as the right thing to do. Surely that, too, still has some value.
Nick Gioia | www.ngrealtygroup.com