Same payment after bubble burst?

[midnight286]

I’m not an economist and I listen to a lot of gossip about the bubble or lack there of from my friends, and I have a question. Some friends of mine have recently decided to buy a condo for around $400K. They believe there is a bubble of sorts, but rationalized this purchase in a way I hadn’t really thought of before. If the housing market crashes because of interest rate hikes, which seems to be at least one reason it would fall, the payment they would be making would be essentially the same because of the increased amount they would be paying for interest on their condo. I did a little uneducated research and came up with a mean interest rate over the years of about 9% give or take, for a 30 year mortgage. I calculated that my 250K mortgage would cost about 800 more a month if interest rates were 9% when I locked in my fixed rate instead of 5.5% That would add 33% onto my payment! My question is, if the housing bubble bursts, is housing affordability actually going to go up? It seems like interest rates returning to normal would require the market to fall very far indeed in order for the average family to be able to make the monthly. Thanks!!

[barnaby33]

Tightening lending standards will get you more affordability than lowering interest rates, though I think in the coming bust both will help. Less people able to borrow means less potential buyers. If your friends have good credit that will be the determining factor in improving affordability as lending institutions will be taking less if any risks. There is a whole passle of things that go along with a bubble bursting that will help some people and hurt others. I honestly can’t think of a scenario that justifies purchasing at this point, unless you are staring in a re-make of brewsters millions and you literally have money burning a hole in your pocket.

Josh

[North County Jim]

Even if their assumption is correct, wouldn’t you rather have the same payment at a higher interest rate? This would increase your chances of refinancing at a lower rate down the road.

[powayseller]

Interesting idea!

This will work only if your friend plans to stay in that condo until prices go back up to today’s levels, i.e. 12 years. If they’re a young couple, perhaps a baby will come along in 3 years, and they’ll want to sell and get a house with a yard. They’ll be upside down on the mortgage. They’ll sell for $200K, and owe the bank $400K. Then they’ll get the $350K house w/ yard, and get the mortgage on that. Now they owe $550K in mortgages.

Even if they stay for 12 years, there is still the interest rate risk. I look at it this way: I am 100% certain that housing will crash, and I’m 80% certain that it will crash by 50% over the next 4 – 6 years. However, I have no idea what the Fed will do with interest rates in 2010, and neither do they.

If housing falls by 50%, interest rates must increase by 50% from today’s levels to break even on the payments, so they must go from 6% to 9% as you said.

If they go higher, your friend wins. As long as they can afford the payments when they are fully adjusted, your friends might be okay with that strategy.

Anyone financing with an ARM has a high likelihood of edning up on foreclosure.com.

Each month they delay their desire for homeownership (delayed gratification, as I teach my kids constantly when they want something), the cost of the condo will go down by $5 – $25K. By fall, that condo might be only $325K, and we know interest rates are not going over 5% by fall.

In closing, they must meet 3 criteria to win this game. If they have a fixed rate mortgage they can afford for at least 12 years (or an ARM where they can make the full payment after it adjusts) and they are guaranteed secure jobs/living situations so they can ride out the bubble, and interest rates go up over 9%, they win.

Best of luck to your friends, and congrats on a well-thought out strategy. It’s a gamble, but it might work for them. I’d advise them to wait. (NOT INVESTMENT ADVICE)

[midnight286]

Betting on refinancing at a lower rate down the road seems risky. Especially if we are talking historically normal rates of 8-9-10% going down to historical lows of 5-6% again.

[midnight286]

This is the problem I worry about for all my friends that are buying right now. We are all couples with median incomes over 100K and yet without downs are still buying 400-500K homes/condos with at least some part of the mortgage adjustable. Historically, has this scenario taken place often?:
‘They’ll be upside down on the mortgage. They’ll sell for $200K, and owe the bank $400K. Then they’ll get the $350K house w/ yard, and get the mortgage on that. Now they owe $550K in mortgages.’
It seems like they would prefer to declare bankruptcy and walk away from it all. I’m young and I’ve never heard of someone paying a mortgage for a home they no longer own. Thanks for your input!

[powayseller]

You’ll get some great feedback from the investors and bankers here.

In the meantime, I know that the IRS considers unpaid mortgages as income, and you are taxed on that. How would you like to pay taxes on the $200K you didn’t even earn while you are in bankruptcy? Plus, you’ll be unable to get another mortgage for 7 years. As lending standards tighten, you won’t qualify for the “1DayOutofBK.com” blue-light special.

Can your friends handle the mortgage in 2 years when it adjusts, and payments double? Are their jobs secure to handle the recession? Remember, SD’s economy is built around us buying/selling homes to each other, and servicing our insatiable demand for clothes, cars, trips, food by spending our home equity. If your job might be affected as these industries consolidate/downsize, be wary of taking on a large mortgage.

[North County Jim]

I’m not saying it’s a good bet. I’m just saying that it’s a better bet than the one your friends are making.

For example, on a $400,000 30 year fixed rate loan at 6%, your payment would be about $2,400. Your payment would be about the same on a $350,000 loan at 7.25%.

For the same property, I’d prefer the latter situation to the former. I have the ability to refinance much earlier in the cycle than I would on the 6% loan.

[Bugs]

The feds recently issued a letter to the lenders warning them to not issue ARMs unless the borrowers can fully debt service the permanent rate. ARM availability has dropped tremendously since then. Having been specifically warned, these lenders can’t get caught going against these instructions later on down the line.

[an]

Even if rates doesn’t go down, buying at a low price high rate is a better choice, because, you can deduct more of your monthly payment since a larger of your monthly payment is interest. Also, any additional payment you make will make a larger dent in the total loan with a high rate/low price case.

[powayseller]

The OCC guidance is under review and open to comments until March 29, 2006. I wonder if the lenders have to follow that, since they are just recommendations, and no penalty is given if those are violated. As long as investors buy the loans, what can the Feds do to stop it?

The OCC document (12/19/05) is rather inert, and does not specify specific risk targets or specific penalties.

The day after the OCC guidance was issued, a mortgage loan officer (housingbubblecasualty.com) wrote on his blog that his company removed BK seasoning! That means that 1 day out of bankruptcy they will give you 100% financing. They didn’t sound too scared by the OCC.

Check out his website, where in January he writes that lenders’ standards keep getting lower (BK, no tradelines), but the investors are more carefully scrutinizing the stated income applications. They are not as easily believing the stated income of the borrowers, and along with the rising interest rates, fewer borrowers are qualifying. One account rep was reprimanded by his manager for not being aggressive enough in the grey areas.

So although I wish the Fed’s guidelines would cause lenders to tighten standards, the evidence for that has yet to come in.

If the Fed had any power at all, you’d think they would have reined in Fannie Mae. What company could admit they have an $11billion accounting problem, are violating GAAP, and not submit financial statements for 2 years?? Senator Rudman formed a Committee to investigate and found nothing further wrong. Although his report is less than a month old, today Fannie Mae admitted that they have many more problems.

Although Fannie Mae operates under a government charter, the Feds have been powerless to rein them in. How much power do they then have over other mortgage companies? Perhaps the power is there, but it boggles the mind that they are choosing to not use it.

By the way, today another person I know showed up on the foreclosure list I track. The fallout from this loose lending is going to happen. The standards, even if they are implemented, are 4 years too late. If the Feds had enforced these standards in 2001, this housing bubble would have been avoided, and we wouldn’t have to witness 10% of our friends going into foreclosure over the next 6 years.

[Bugs]

In all fairness they’re damned if they do and damned if they don’t. Had they been more agressive earlier on they would have been accused of being a drag on free enterprise. we expect our government to be reactive and to let us do what we want. That is, right up until it’s too later – then it’s 20-20 hindsight all the way.

[sdduuuude]

That’s a nice little analysis.

[North County Jim]

Thanks duuude!

[sdduuuude]

I’m a broken record on this point, but I have used it a few times in the past year to convince several friends not to buy condos – two of which have already dropped in price while the others haven’t appreciated at all.

Your friends really need to look at the cost of renting vs. the total cost of ownership over the next several years. Insted of worrying about the payment, look at total asset value – cash and equity at the end of 5 years.

In my ‘hood, you can rent a place for $2000 that would cost $600K to purchase.

Ditech tells me the monthly payment would be $3,794 on a fixed rate loan at 6.5% with nothing down. Add 1.25% for taxes (I think) => (600K * .0125 / 12) = $625/month.

Add another $50/month for insurance.

You might have some PMI in there also – call it $100/month, which is surely too low.

TOTAL PAYMENT: $4569.

This means, if you can afford a $4569 payment, you could rent for $2,000/mo and put $2569 per month into the bank. After five years, you would have put $154,000 into the bank. I’m to lazy to do the interest calc, but you would have more than $160K in the bank after five years !!!!!

This is $160,000 you won’t have if you buy and you could lose equity.

In 5 years you could put a down payment on a house at a lower price with a higher interest rate and be sitting pretty.

One of my friends was going to purchase a place in City Heights with a Principal and Interest Payment of $1900 per month. She pays $800/month to live in PB now. Thank god I stopped her.

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