Underwater Subprime Mortgages – Is the Sky Really Falling?

by Mike Holman

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algonquin1.JPG

Algonquin sky

I’ve been reading some “sky is falling” articles lately regarding underwater mortgages or upside down mortgages, where the amount owed by the house owner is greater than the value of the home.  These are often referenced in the same sentence as subprime mortgages.
Maybe I’m missing something, but I just don’t understand the big deal over the fact that some house owners have bigger mortgages than the house is worth. I certainly appreciate that this is not a desirable situation but I don’t see how the “sky is falling” attitude is anywhere near reality.

If your house is worth less than the mortgage, should you walk?

Imagine someone who finances a brand new car with small down payment. That new car owner was probably “underwater” on their car loan about three minutes after they drove it off the lot. Should they bring the car back to the dealership and “hand in the keys”? Should they abandon it in a field or lake somewhere? Probably not – they might just want to keep driving it and unless they had some major financial situation occur like a job loss or medical emergency, then they should just keep going with the payments regardless of what the car is worth.
How did this horrible situation occur? Well probably because they only purchased a small amount of equity in the car when they bought it, which of course disappears very quickly since new cars depreciate quite a bit at the beginning.
If someone buys a house with little or nothing down, then it obviously doesn’t take much of a price drop for them to be underwater on their loan. Is this such a bad thing? Nope. The key is the payments. Since you still have to pay for a roof over your head, as long as you can afford the house payments (within reason of course) then you shouldn’t even worry too much about the house value or consider giving up the house.
Of course there are some situations where an underwater house is a problem – generally if you want to sell it because you are moving to another city or area or because you can’t afford the payments. In that case there is not much you can do – sell the house, assume the loss and add it to your debt and move on. And save the paperwork for the next idiot who thinks that real estate is always a great investment.

What if my real estate investment property or flip is underwater?

Mmmm…tough luck? Even if you end up losing a lot of money you will at least get the satisfaction of learning a hard-earned lesson about risk, leverage and real estate investing.
Bottom line is that it’s easy to look at the raw statistics and draw whatever conclusions you feel like. Equating the number of home owners who are upside down on the their mortgage with home abandonment or a major financial crisis is faulty logic.

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{ 16 comments… read them below or add one }

1 The Financial Blogger

Properties are like stocks; it does happen that you can be underwater!

I agree with you. As long as you can make your payments, there is not much impact.

I think the problem lies where many mortgage companies in the States did loans only based on the market. They basically “used” their clients to buy a property that they can’t afford thinking they would get it back within a year or two and keep the increase in value for themselves. They guessed wrong ;-)

2 Emily

Love that Algonquin sky!

I don’t really get all of it either. Make your payments, keep your roof over your head. Ride this out and there’s not a huge panic.

3 Four Pillars

Very true FB – there certainly are situations where being underwater changes things a lot.

Emily – I was going to email you to check out the photo. Glad you like it.

4 guinness416

I agree; I couldn’t even tell you what my house is worth. I wonder sometimes about bloggers who manipulate their house value up and down in trying to calculate their net worth. It seems like a stressful exercise and one that has the potential to be wildly wrong.

But I feel the same way about most articles about people freaking out to the point of making themselves ill about retirement account values and so forth – I don’t recognize that level of stress in people around me.

5 Debt Free Revolution

Well, this is one less post I have to write! LOL I’ve had the idea of comparing these “underwater” mortgages to financing a vehicle (it doesn’t even need to be new) because IMO the analogy FITS to a T.

Oh, everyone mark your calendars: Mike-FP and I have actually agreed on something in regards to a mortgage LOL ;)

6 Mr. Cheap

I agree completely with this post for people who are buying property to live in (i.e. getting their dream house to raise their kids in). I think the problem with underwater mortgages occurs when people have bought property as an INVESTMENT. People expect cars to depreciate, but there’s a cult that feels real estate can only go up, up, up.

Someone buys the maximum house they can afford, expecting to brag to their friends about all the equity they have. The market starts dropping, and instead they own a house worth less than the mortgage. Each month they get bitter as they’re eating ramen for a property that they thought was going to make them tons of money, but instead they’re just trying to work off the debt.

Down in the states, mortgages are typically non-recourse (so you hand in the keys and that’s the end of it – they can’t go after your other assets). This isn’t the case in Canada or the UK.

People who are sick of paying on property that isn’t making them rich and famous hand in their keys. The bank sells their house for whatever they can get for it, which lowers the average selling price in the neighborhood, which puts other people under water, which keeps the cycle going.

I think corrections are good (or at least necessary), and they shake out the weenies who don’t understand their investment and aren’t in it for the long term.

I don’t expect people happily living in a house they like to walk, but I do expect “investors” to consider walking. What proportion of homeowners falls into each group I don’t know…

7 Four Pillars

Guinness – I’m always amazed at bloggers who can somehow calculate that their house went up 0.4% last month when in my opinion, even a professional estimator probably couldn’t estimate a house within 5%!

DFR – I’m glad we agree. I think you should do the post anyways. I’m sure you will have a different take/slant on it.

Cheap – good point. It’s odd that you can just walk away from a mortgage in the US. I wonder why they would allow that?

8 Steward

Great article. I agree with what has already been said about viewing the problem of under water mortgages differently if we are talking about a home investor or a home owner. Home owners should stick it out and investors should evaluate their position from an investment standpoint.

However, contra Mr. Cheap, I am of the opinion that real estate can only go up, up, up, up in the long term if two conditions are present: (1) there is only a certain amount of land, and (2) more people want to live on that land than did a few years ago. Since I don’t see these two conditions changing any time in my lifetime, or that of my grandchildren, or even that of my grandchildren’s grandchildren then I think real estate will always be a good long term investment (unless the government gets all imminent domain on your heiny, then I recommend gun ownership).

9 Gates VP

Hey FP;

Nothing like a little tough love. I’m with you completely on this one.

Complaining about being underwater on your mortgage is just outright foolishness and demonstrates a severe lack of “finances 101″. I hope that everyone there reads your blog post.

10 growthinvalue

Equating the number of home owners who are upside down on the their mortgage with home abandonment or a major financial crisis is faulty logic.

I get what you’re saying, but I’m not sure it’s quite correct, as it’s written here. I may not be logical, but that doesn’t mean people won’t do it. So the number of “upside-down” homeowners seems as decent a proxy for the housing market’s health as some of the others that get bandied about.

The fact is, a lot of people new to the real estate game will panic and sell at a loss once they’re upside down, regardless of the fact that it’s a stupid thing to do.

11 Kyle

For all I know I’m underwater. I have no idea since I haven’t checked to see what my condo is worth in the last year. It doesn’t particularly bother me since I’m not selling anytime soon.

12 Four Pillars

Steward – the long term real estate return is inflation plus a bit so you are probably right (in the long term).

Gates – the more people that read it – the better!

GIV – I really hope that home owners don’t panic.

Kyle – that’s the right attitude.

13 Hustle Strategy

I guess I am looking at this a bit differently but, from my understanding…

People got into loans that they could not afford, where the interest would increase over time. Based on this increased interest people are in a sub prime crisis. Because of this they are looking to refinance to get better terms, but they cannot refinance because the value of the homes have decreased.

Therefore people have to jump. They have few other options. Paying rent for some is more difficult then others. Some have jumped in over their heads…

14 Mark

Original purchase money (not refinanced, or HELOC) mortgages on principal resididences are only non-recourse in a very small number of states (ie: California) in the US. Since most people in trouble refinanced at least once or twice in the past few years, this describes virtually nobody who is ‘upside down’. I don’t know why many commentators continually drag this fact out into discourse, because, practically speaking, the non-recourse nature of a small number of loans in the US is meaningless.

The major difference between the US, and Canadian/UK markets is the availability of long-term financing without the risk of margin calls and rate resets. Most loans written in Canada have a margin call provision every 5 years, along with a rate reset. In America, you can get a true 30-year loan quite inexpensively, which allows people to take on commensurately more risk and elevates pricing.

15 Four Pillars

Thanks for the info Mark.

Good point about the long term fixed mortgages available in the US – I don’t know why they aren’t available anywhere else – I suspect there is more competition in the US banking industry?

Mike

16 Brian

I don’t know how old this post is, but I had something to add.

When it comes time to renew the mortgage, you’ll have to renew with your current lender at their posted rates.

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