Desperate House Buyers Increase Foreclosure Risk

You don't need me to tell you that real estate purchases (for homes and for investments) has gotten out of hand. But just to put some facts to the story, I thought I'd share this article from USA Today that talks about some of the events that are leading us toward higher foreclosure rates:

The meteoric rise in home prices has been accompanied by a sharp shrinkage in the size of down payments made by cash-strapped buyers, a trend that could portend a spike in future foreclosures, new research shows.

Nearly four out of 10 (38.1%) home buyers who bought houses in the first half of 2005 put down less than 5% of the purchase price, up from 30.6% in 2000, according to a study released Tuesday by SMR Research, a Hackettstown, N.J., firm that tracks mortgage debt. Nearly half (49.9%) of buyers put down less than 10%, up from 44.8% in 2000.

Another potential red flag is the growing use of so-called piggyback loans.

Traditionally, home buyers who did not come up with a 20% down payment had to pay an added cost each month for private mortgage insurance. But recently, more strapped borrowers are taking out two loans — one for 80% of the purchase price and a second, or piggyback, loan in the form of a line of credit or home equity loan. So far this year, nearly half (48.2%) of buyers used piggybacks, up sharply from 19.9% in 2001.

The statistics suggest that many home buyers are stretching their budgets well beyond their means. The risk is that recent buyers have such minuscule equity in their homes that if prices fall, they could owe more on their mortgages than their homes are worth.

Read those last two sentences again. The main issue is that "many home buyers are stretching their budgets well beyond their means." Is anyone surprised at this statement? I'm not. I think it's been happening for a long time. Just think about what's happening with credit cards and the same thing is going on here -- people can't control their wants. The must have more, bigger, better, etc.

And what's the potential fallout from this sort of financial situation? That home prices could fall (which seems more likely in the short-term that the massive increases we've seen recently) and people end up owing more than their home is worth. I tell you, being upside down on your home is a pretty bad situation -- especially if you must sell for some reason.

The piece goes on to add some insight into why this is happening:

The National Association of Realtors says the median price of an existing home rose 13.6% to $208,500 from the second quarter of 2004 to the second quarter of 2005. "As home prices rise, people can't afford them," says Stuart Feldstein, president of SMR. The study, he adds, highlights the fact that most people haven't saved enough money to buy ever-more-expensive homes. Home buyers are "using much more leverage," he says.

Americans' ability to take on massive mortgage debt has been fueled by the availability of "exotic" mortgages, such as interest-only loans and adjustable-rate mortgages that provide borrowers with a lower monthly payment for a short period of time, says Dean Baker, co-director at the Center for Economic and Policy Research.

"Home prices are going through the roof, forcing people to turn to exotic loans and unorthodox financing," says Baker. "These people have no room for error."

SMR warned that the risk of foreclosures rises when borrowers take out loans in excess of 80% of a home's purchase price. While rising prices have reduced some of that risk, the "future foreclosure risk is rising," SMR claims.

Here are my recommendations on home buying:

1. Save up a down payment of at least 20%.

2. Buy a house where you can comfortably make the payments. If you can't find one, you either need to move to another area or get a better job/more income.

3. Pay off your mortgage as soon as you can by making extra payments. I know I'll get a lot of "here's why you shouldn't do that" comments and email, but these are MY recommendations. It's what I've done in the past, and it's worked out pretty well for me.

Update: Linking to the Beltway Traffic Jam.

Comments

[savvy saver]

I agree with you. Too many people see their home as something that will forever and ever increase in value at a remarkable rate. Some people are even buying real estate out of fear of being "left out" and they are putting no money down and buying properties they can't afford with adjustable rate mortgages - even in the more moderately priced midwest!

[Keith]

I agree in general with the advice, except for point #3. Making extra payments on your house is a form of savings, but it is very illiquid. The only ways to get the money back if you need it are to a) get a home equity loan and pay interest on your own money, or b) sell your house.

My personal strategy is to have the GOAL of paying off my house early but to do it by saving the money in my own savings account and mutual fund. Then I have the liquidity, in case I lose my job or some bad illness comes along, but I'm still building up enough money to pay off my mortgage. While I build it up, I have my "safety net" savings, but when I have enough, I'll pay off the entire loan at once and be free and clear. Once the house is paid off, I don't need the same kind of liquidity because my monthly burn rate is so much lower.

Also, in these days of 4.5% mortgages, prepaying your loan is not a very good return to expect compared to long-term savings in a diversified portfolio.

My $.02....

[YoungMiser]

I definately would second putting at least 20% down on a house. This will pad a person if the value goes down a bit, plus will help even more if the house increases in value. I also think a person mortgage payment should not be more than 25% of their NET income.

I wrote an article regarding this issue a few weeks back, in a serious I posted about buying my first house.

http://www.youngmiser.com/2005/08/17/buying-a-house-can-i-afford-it/