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mortgages

Walking Away from a Mortgage: Is it immoral?

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Late last year, University of Arizona law professor Brent White stirred up some controversy by observing that underwater homeowners should feel no guilt about walking away from properties whose value has fallen way below the amount owed on them. Pointing out that the very lenders who cooked up questionable residential mortgages feel no compunction about walking away from underwater commercial properties, White pointed out that buying a residential property is no less a business transaction than buying a commercial one, and that mixing emotion and “morality” into the transaction has saddled homeowners with a disproportionate burden for the current real estate fiasco.

Cutting one’s losses when a property is no longer worth what you’re paying for it is called “strategic default.” Despite the clear fact that a real estate transaction is a real estate transaction, many people can’t get past the idea that individuals, as opposed to corporations, have some moral obligation to stick with a bad business deal. Others argue that what’s good for the corporate goose is good for the individual gander. Just check out some of the comments here and here and here.

The story’s not quite as simple as it seems on the surface. Depending on what state you live in, you may or may not be able to hand a property back to the bank without consequence. In some states, lenders can come after an owner who walks or does a short sale for the difference between the house’s selling price and the amount of the loan. Your credit rating, of course, will be trashed for several years to come. And if Soggy Bottom is not your primary residence, you’ll owe taxes on the amount you defaulted on.

IMHO, White has got something. If you’re stuck with a bad loan for your primary residence and you live in a state where a lender can’t sue you for a deficiency judgment (such as Arizona), it may be financially irresponsible NOT to walk. And there’s no reason to feel guilty or morally incompetent when the mess results from no fault of your own.

M’hijito and I copurchased a small house in mid-town Phoenix’s established, mostly middle-class north central corridor at a time when we believed the real estate collapse was nearing bottom. Our agent, a very smart older man with an MBA and many years of experience in business and real estate, thought the same thing. We estimated the house’s value would drop about $4,000 to $6,000, level out for a year or two, and then begin to rise at about 3% to 6% p.a., the historic rate of increase in that area before the bubble.

Neighbors were furious with our seller for unloading the house at what they thought was a rapaciously low price.

How wrong could we all have been?

The house is now worth (if you believe Zillow) $75,000 less than we paid for it and $51,000 less than we owe.

We planned to hold the house for five to ten years, with M’hijito living in it most of the time or renting it should he take a job in another city or marry and need a larger home. After no more than a decade, at which time I planned to retire, we expected to collect a small profit or at least break even, split whatever equity we recovered, and go on our respective ways.

Now M’hijito feels stuck in the house. Because we can’t even begin to sell the house for what we owe on it, he can’t move to another city in search of a better job (workers are famously underpaid in Arizona) or go out of state to pursue an MBA at a decent school. Having lost my job and seen my retirement savings plummet $180,000 when the Bush economy crashed, I’m in a different financial position (indeed) than I was when we bought the place.

Fortunately, we did have enough sense to get a loan through our credit union. Unlike the banks of recent infamy, the credit union has been willing to negotiate. But they resist even contemplating a cut in principal, which is what needs to happen.

In response to my layoff from ASU, the credit union arranged to prorate our payments over 40 years (instead of 30) and to cut our interest rate to 4 percent. This dropped the mortgage payments into a more affordable range—and to something close to what we could theoretically get in rent.

The deal is good for only a year, however. After that, the credit union will consider renewing it for another year or will give us the option to refinance.

Although of course I’m pleased to see our payments reduced to something almost within reason, I’m still unhappy with the underlying predicament: the house’s value has dropped so drastically that we may never recover our investment in it, and so money paid toward the loan amounts to money down the drain. In an optimistic scenario, it will be another ten years before the house’s value rises to what we owe on the mortgage—to say nothing of the healthy down payment we put down at the outset. And please: don’t even ask what it costs to renovate a 1950 cottage!

For the time being, M’hijito likes the house and is comfortable there. He rents one of the rooms to bring in cash to cover maintenance and repairs. And with the mortgage adjustment, the roof over his head is costing him no more than he would pay for a rental. But the point is, we’re both losing money on the property.

We did everything we could to make a responsible decision: purchasing a house that was certainly no McMansion, selecting a centrally located neighborhood ripe for gentrification and close to the much-ballyhooed lightrail line, buying within our means, avoiding shady mortgage instruments, and selecting a lender that was unlikely to rip us off. And we’re still behind the 8-ball.

A corporation’s board of directors would be remiss not to default under those circumstances. So…should a homeowner be held to a different standard? If so, why?

Image: Tennessee house, ca. 1933-36. Tennessee Valley Authority. Public Domain.

Financial Freedom: Own the roof over your head

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Life on the treadmill

We’ve been talking, on and off, about routes to financial freedom, defined as a life off the day-job treadmill that leaves you free to do what you want to do with your time, not what someone else decides you should do. It takes time to achieve this freedom. You need get enough education or vocational training to land a job that will produce enough income to allow you to build some savings, and you need to live not only within that income but below it. An important part of your early-escape strategy is to get a roof over your head that’s paid for.

Yes. Pay off your mortgage.

In some circles, that’s tantamount to sacrilege. But the fact is, the largest chunk of cash flying out most people’s doors is the mortgage payment, and most of that payment consists of interest. The putative income tax break, if you look hard at it, is negligible compared to the amount of money that goes down the toilet in the form of loan interest. Mortgage interest can more than double the amount you end up paying for your house.

If you have a program like Quicken, it’s easy to figure that amount. Using the loan calculator, enter your principal, the interest rate, and the number of months to pay-off, and the program will generate an amortization schedule showing, in detail, how much each payment reduces the principal and how much, in total, you will have paid by x or y date. You can accomplish the same calculation, though, with Excel or an open-source spreadsheet. Over at The Simple Dollar, Trent provides an easy step-by-step guide to setting up your own loan calculator in Excel.

However you arrive at the full picture, what you find can be startling. M’hijito and I owe $211,000 on the downtown house. At 4.3 percent, over 30  years we will pay $164,907 in interest alone, meaning that if we hang onto the place that long (and it this point it appears we will be forced to do so), we will pay almost $376,000 for the house. When I bought my first house, I paid $100,000 for it, borrowing $80,000 at 8.2 percent on a 30-year traditional loan. At that rate, I would have paid $169,200 for interest alone, way more than doubling the ultimate price of the house.

Whether it’s worth that much in 30 years is beside the point. The point is, a $211,000 mortgage represents $376,000 that doesn’t go into savings. It’s $376,000 that doesn’t go toward achieving bumhood. Every month that we pay toward this loan is a month that a principal-and-interest payment of $1,044 goes into someone else’s pocket.

If he were paying toward rent instead, that also would be money down the toilet: the renter puts money in someone else’s pocket with no hope of ever owning anything and no end to the outgo. At least when you buy a house, you have a chance of paying it off and putting a roof over your head that costs you little or nothing, from day to day.

(It must be noted, though that owning your house is never free. You still will owe taxes on it, and you’re crazy if you don’t buy insurance. Maintenance and repair costs can be significant. These expenses require most mortgage-liberated homeowners to self-escrow something each month in an account to cover such costs.)

The key to bumhood is getting out of debt, and that includes mortgage debt. A thousand bucks (or more) that stays in your pocket each month represents a large fraction of the amount a bum needs to live in comfort and contentment. Given that a person who lives modestly in a city with a reasonable cost of living really needs only about $2,000 to $3,000 net a month, a thousand dollars gets you a third to half-way there!

So…how on earth do you go about doing this? The cost of a house is crushing. What human being can possibly afford to pay for one in full in anything less than an adult lifetime?

Well, I suspect most people can. Here’s the strategy:

1. Buy a house that’s within your means.

Where is it written that you have to live like Pharoah? No one really needs a McMansion. Many smaller houses offer charm, comfort, decent neighborhoods, and ease of maintenance.

If living in a prestigious district is your thing, look for middle-class neighborhoods that border fancier areas. My house, for example, is in a very ordinary neighborhood that abuts a district of million-dollar homes, two blocks from a lovely park. Obviously, if you have kids the school district is important, and so you’ll need to add that consideration into your calculation. It’s worth investigating whether sending a child or two to parochial or private school might actually be cheaper than buying a more expensive house in an area with top-rated public schools, especially if you can qualify for scholarships or tuition assistance.

2. Get the shortest conventional loan you can manage.

Because interest rates on a 15-year loan are lower than those for a 30-year loan, the payments are not that much higher. For example, with a 6.5 percent rate on a 15-year loan for my original $100,000 home, the principal and interest would have been only $128 more than what I was paying toward the 30-year instrument.

Never take on a variable-rate mortgage. Adjustable rates always adjust upwards. Even when the prime rate goes down, banks find excuses to raise the mortgage payments.

And, given the communal experience of the past couple of years, we know never to accept anything “creative” from the loan department.

3. Pay extra toward principal.

Even if you have a 30-year loan, you can speed the payoff date by paying down principal each month or, if you’re paid semiweekly, by applying some or all of your so-called “extra” paychecks to principal. Another strategy is to apply all of one spouse’s net salary to principal, if you can afford to live on one partner’s income.

The downtown house, for example, cost so much that there was no way we could have made payments on a 15-year basis. However, if we added $130 a month in principal payments, we would pay the house off in 24 years instead of 30. Applying all of his roommate’s $400/month rent payment toward principal would pay the loan in a little over 17 years. Combine the two—$130 out of our pocket and $400 from the renter—and we could kill the loan in 15 years.

4. Build side income streams and apply that money to principal.

A spouse’s salary, a second job, a roommate, a hobby monetized: all these sources of cash can be used to pay down the mortgage. Because lowering principal cuts the interest portion of future payments, it’s helpful to pay extra toward principal on a regular basis (whether it’s monthly, quarterly, semiannually, or even just once a year). But no law says the extra payments can’t be sporadic. Whenever you get a chance to earn extra money, take it, and then use the net to pay down the loan.

5. Apply all windfalls to principal.

I paid off my first house by saving every post-tax penny of spousal support (having lucked into a decently paid job) and investing it. About five years after I bought the house, I used the cash I’d saved plus a small inheritance to pay off the mortgage.

Was it easy to break a chunk out of my savings to throw at the house? Nope. Have I ever regretted it? Nope.

It probably was the smartest thing I ever did. Once SDXB moved out, I could not have paid the PITI and survived on my net income without a roommate or a domestic partner, neither of which was in the cards. The house’s value continued to grow, so that when I was ready to move to a somewhat nicer house in a quieter corner of the neighborhood, I could pay for the next place in cash. And when I was laid off my job, there was no worry about whether I would lose my home.

6. Choose your house wisely.

Purchase with an eye to staying in the place permanently. That’s right: for the rest of your life. Consider whether the neighborhood is likely to remain stable or even improve over several decades, and whether the construction will stand the test of time.

Remember, your house’s value will increase in lockstep with all the other real estate in your area. While the place may appear to double in value over 15 or 20 years, so has everyplace else! This means that if you’ve paid off your mortgage and you want to avoid taking on new mortgage payments when you move, you’ll have to buy a comparable house. Paying off a mortgage means that you’ll be living in similar housing forever, unless you’re willing to take on new debt.

As you can see, this project entails some trade-offs. Unless you earn a ton of money, you likely will not be living in an elegant palace. To get into a decent school district, you may have to take a lesser house than you could have afforded in a neighborhood with weaker public schools. And you’ll need to seek contentment and ego gratification from sources other than real estate, downsizing your housing expectations to fit your long-term goal.

Freedom’s not free. But it’s worth it.

Financial Freedom:

• An Overview
• Education
• Work
• Debt
• The health insurance hurdle

Image: U.S. Air Force Photo/Staff Sgt Araceli Alarcon. Public domain.

Mortgages: Is a 30-year mortgage better than a 15-year loan?

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Over at Room Farm, proprietor Chance is offering an article she wrote some time back for Living Almost Large, in which she argues that it’s better to stretch your finances (and by implication, to select a cheaper house) and get a 15-year mortgage than to pay for real estate with a 30-year mortgage. Readers at LAL squawked that it’s impossible to afford a 15-year loan, given the outrageous cost of real estate, and when last seen, Room Farm readers were echoing that and suggesting it’s better to go for 30 years and pay extra toward principal. This strategy gives you an “out” if you run into hard times, in the form of payments-due that are really smaller than what you habitually into the loan.

Let’s consider how affordable a 30-year mortgage really is when compared to a 15-year loan. Real estate has dropped so drastically, it’s now possible to find good housing at prices that allow buyers to consider the shorter repayment term.

As an example, one of my research assistants and her husband just purchased a house in the high-rent district of my part of town. Buying the place out of an estate (it wasn’t a foreclosure—the heirs just wanted to unload it fast), they grabbed a nice house with a pool on a big corner lot amid a cluster of $500,000 homes. Their cost: $225,000.

The dollar difference between payments on 15- and 30-year loans is a lot when you’re talking about the $200,000 range. Let’s say the young people put only 10 grand down and finance $215,000. Right now a 30-year fixed mortgage from our credit union is at 4.625 percent: monthly principal & interest would be $1,105. A 15-year mortgage is at 4.375 percent: $1,631 a month.

However: On the 15-year loan, the first payment covers $847.18 of principal and $783.85 of interest. For the 30-year loan, only $276.74 goes toward principal; the remainder forks over $828.65 in interest.

Three years later, the principal on the 15-year loan is $962.26, and the interest is $668.77. The 30-year loan is applying $316.63 toward principal and charging $788.76 in interest.

How does this look halfway through each loan?

Seven and a half years into the 15-year loan, the buyer would be putting $1171.22 toward principal and only $459.81 into interest. The 30-year loan doesn’t reach its halfway point for 15 years (by then the person with the 15-year mortgage is having a mortgage-burning party!). After 15 years, the buyer with the 30-year loan is still shoveling half the payments into interest: $550.96 pays down principal, and $554.43 goes toward interest.

Let’s say each buyer stays in the house until the mortgage is paid off. At the end of the loan periods, assuming neither buyer has paid extra toward principal, the 15-year loan has cost its purchaser $78,526.24, but the 30-year loan has relieved its buyer of $182,948.10.

For the borrower, interest is money down the toilet. You might as well shred hundred-dollar bills and flush them. Seventy-eight grand is quite enough to fork over for the privilege of paying an astronomical amount to keep a roof over your head!

I would agree with Chance: you’re better off buying a lesser house and straining every muscle and sinew to pay it off in 15 years than you are to diddle away 2.32 times as much interest on the 30-year loan. The alleged savings in taxes are negligible compared to the amount you’re paying on interest over the term of the loan.

If, as some people suggest, you apply an amount equivalent to 10% of the monthly payment to principal, you’re not paying as much interest as you would on the 15-year loan, but neither are you knocking down principal much. Ten percent of our proposed loan payment is only $110: that’s +-$526 short of the amount needed to reduce the 30-year loan to 15 years. Although it is true that the extra payment toward interest would mean that 15 years into the loan principal payments would be higher than interest ($659.96 vs. $445.43), at the end of the loan this buyer has still paid $146,783.23 in interest. That’s almost twice as much she would have paid had she taken out a 15-year loan.

If our buyers can’t afford the higher payment needed to pay their loan in 15 years, maybe they would be wise look for a cheaper house.

Principal and interest figures calculated in Quicken 2006 for Mac.

The refinance is here

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Yesterday M’hijito and I signed the papers on the refinance for the Investment House. It drops our payments about $200 a month, not quite as much as we’d hoped, but better than a hit on the head.

It’s a 30/15 loan: the payments are calculated on a 30-year basis, but the balance is due in 15 years. We don’t expect to own the house that long-the initial plan was to hold it for five years; we’re now thinking we may keep it 10 years, to give the real estate market time to fully recover. But it’s unlikely he will keep it much longer than that.

If the house is actually worth $250,000 today (I’ll believe that when I see it) and it accrues in value at 5%, a reasonable figure, in 10 years its value will be $407,200. We will owe $176,000 at that time, giving us equity of $231,223. Sounds great, till you figure in the $105,808 we will have paid in interest.

However, let’s suppose he realizes he wants to stay in that centrally located neighborhood for more than ten years, and suppose he wants to get out from under the mortgage:

According to Quicken, if he makes the regular payments on the new mortgage, in 15 years we will owe $147,860.

If he continued to pay at the old rate, putting the extra $200 toward principal, in 15 years he would owe $92,695.

If he paid $300/month toward principal, in 15 years the balance would be $65,112.

And an extra $500 a month would reduce the balance to $9,948 over 15 years and would completely pay off the mortgage in 15 years and 6 months.

Financially, one would no doubt be better off putting extra money into the stock market, unless one wanted to own a piece of property free and clear. Fifteen years is a long haul, and during that time compounding interest will probably grow a mutual fund more than the value of the house itself will grow, especially since it will probably take five years or more for the real estate market to fully rebound. By then he’ll still be twenty years shy of retirement and he will be earning a lot more money, and so there really would be no need for him to own property free and clear. Investing the difference between the old and the new loan would be smarter than paying off the house.

M’hijito has talked about renting instead of selling. I think we could rent the house even now for the mortgage payment, especially if we desert-landscaped the yard. Within three to five years, the amount of the mortgage will be well within the going rate for house rentals. It might make sense, if the house is to be used as a rental, to pay down the mortgage so that a future renter will, in effect, pay off the loan completely before we’re ready to sell the place.