Help a Reader: Saving versus Mortgage

Here's an email I recently received from a reader:

I purchased a home in 2006 for 325k.  Since then the value has gone down and similar homes in my area are going for 199k on a good day.   It was purchased with two mortgages, the first being 259k five year adjustable rate interest only mortgage at 6.375% (due to adjust in 0ct 2010) and a second mortgage thats principal and interest for 70k fixed at 7.1% (currently at 63k).  So total its 322k. 

The adjustable rate mortgage uses a libor rate index and a 2.25 margin to adjust come oct 2010 (this means that if the libor rate at that time is 2% our new rate will be 4.25).  This rate change can only go up by two percentage points a year after the first adjustment no matter what the libor rate is.  

We have no plans on moving for the next ten years or so.  Me and my wife have a combined income of 120k with no other debt except for the two mortgages.  We currently take home 7100 base a month (monthly needs 4500) from our jobs and we will maybe make another 500 a month if I pass all my classes.  We might work some overtime, and usually do.  Currently we contribute about 7800 a year to our retirement with another 5200 from matching funds for a total of 13k. 

Now that we are debt free except the house we are not sure if we should direct all leftover money to the house and not max out retirement or push retirement up to 20k and give what we have leftover to the house.  The reason being is even if we try to kill the principal on the first mortgage (by 15-20k a year) we won't be able to refi do to being upside down.  We also plan to have a baby in 2011 so we would also be saving for that, not to mention we need some spending money.  I'd like to know what you and your readers would do.

Any thoughts for him?

Comments

[Susan]

The "reader" provides no info on status of emergency fund or other (non-retirement) savings. If they don't have a 6-8 month emergency fund of $36,000 or so (8 x $4500 monthly living expenses), I would focus on establishing that first.

After that, save $$ for baby expenses. DH and I probably spent around $2k when we had our baby last year (that paid for nursery furniture and all other "baby gear" items we didn't receive as gifts). I would save up at least $3k to have a nice cushion. (You can get by spending less, but we bought quality furniture that will last her until college). Then add on any extra $$ to cover unpaid maternity leave, if applicable. Also, if day care is in the cards, increase the emergency fund above by whatever the monthly day care costs will be. If one of you is laid off, you probably won't want to give up your day care slot because you may not get it back when you find work.

After that, max out retirement savings, if you plan to be in the house for a while. Property values will come back up (although not as quickly as they did before). Then put all extra $$ to paying down mortgages. Then refi when you can.

[Jim]

My priorities would be:
1) fund my emergency fund with 6 months expenses
/ & save for that baby you're planning next year
2) jump retirement up to $20k
3) pay down that 2nd mortgage

Sounds like they are probably already contributing to 401k's up to the point of the match. Thats good. If not then I'd do that for sure.

I'd also consider putting some money into Roth IRA's separate from your 401k's. Another few thousand would give you a very health retirement savings level.

Seems like they have a pretty good surplus income. They take home 7100 and have expenses of 4500. Thats $2600 a month or over $31k a year to save. Thats plenty to pump up the retirement to $20k a year AND throw some extra into the mortgage. Paying down that 2nd mortgage would reduce total debt on the house and get rid of a 7% interest payment on their money.

[BillV]

Jim's and Susan's advice is pretty solid. I might suggest that the old 6 month emergency fund s/b 12 months these days. I have one concern though: combined income is 120k. What happens to that when the baby comes? How long is Mom going to stay at home, one month/three/6 years? Or does she work from home?

Susan, sorry what is DH? Designated Husband/ Divorced husband/Danish Husband? >;-}

[Katharine]

I would throw money at the second mortgage like it was going out of style.

[billyjobob]

My wife and me paid off our morgage in 4 years back in the early 80's. We did that because back then our interest rate was 12 %. I've always felt it was one of the best things we ever did. Not having any house payment for all those years since, has allowed me to save alot of money. If it was me... I would still go for paying off the morgage as fast as possible. Since your rate is not too high, and your income is good. Do both...like you said. Max out the retirement for the tax advantage and then bust your butt to pay off the house too. If you ever run into financial trouble you can back off on the house payment a little. If you've got a lot of principle payed off ahead. Its sort of like a safety net too. That is...if you ever can't make a payment..you would already be payed ahead anyway.

[indio]

I agree with all of the advice about having a solid EF. If you're planning a baby that EF should be higher since you need more security when you have dependents. When calculating EF, don't forget to figure in COBRA and travel expenses while looking for a new job(s). Also, day care, preschool, car seats, everything associated with having kids is very expensive (I know everyone says that but you don't realize how much outlay until you're in the midst of it. Diapers alone are ridiculous and they grow out of clothes in a blink of an eye.). Once you have children then you'll want to start saving for college. At today's rates, the experts recommend $400 per month, for public school, if you start the minute the kid is born.
If the option is save for retirement or pay down mortgage, I say start with the retirement. Compounding is an incredible motivator. After you have kids, it's hard to max out retirement savings. I had $200k in 401k before I had 1st kid. Now I don't feel as much financial pressure when the kids ask for swimming classes, etc because my money is already growing without major ongoing investment (though I'm still trying to recover from last year).
If the option is 1st vs 2nd mortgage, I would focus on paying down the 2nd mortgage because that may have a shorter timeframe when it is due. Given current interest rates, I'd begin the refinancing process now and get it all rolled into one mortgage with a low fixed 30 yr rate. With a 10yr horizon to move, the housing market might recover by then so there is a glimmer of hope. I would try to work as much overtime as you can now, before the baby, and throw as much cash as you can at it.

[Old Limey]

You borrowed $329K to cover all costs of buying a home for $325K which indicates you didn't put down any money to move in. The home is optimistically valued at $199K which would net a lot less after commissions and closing costs. You have an interest only loan and a fixed loan at 7.1% - not good. You mention having a baby in 2011, that translates to either your wife giving up her job or some very expensive care for the baby.
You're young so what's wrong with walking away, becoming a renter for a while, and saving as hard as you can. Let the lenders worry about the bad loans - not you. Just accept that your timing couldn't have been worse and move on. Think yourself lucky that, unlike the stockmarket, you are able to take a huge loss but not get hurt personally.
Of course if you think that this economy is soon going to return to the "Old Normal" then staying put may work out OK but none of the expert opinions that I read are talking about a rapid recovery any time soon.
Of course with this approach your credit will be ruined for many years but just think how much money you will be able to save by shedding two mortgage payments, insurance, and property taxes and giving up the dream of owning your own home for a while. There are many rentals available these days at very attractive prices.
Optimism is nice but Reality is better.

[Jim]

Old Limey raises a good point. Walking away from the home may be a good option financially speaking. They are about $125k under water. Thats a big hole to dig out of. It would take home prices go up 5% a year for a decade for that $200k house to get back to $325 prices. It will probably take longer to recover that value.

Since they plan to be in the home 10 years it might be worth it for them to keep paying the mortgage. Really depends on how much rents are going for versus the mortgage costs and how much they feel digging out of a $125k hole is worth it to stay in that house and keep their credit in good shape.

[Jim]

Another possible option, if the home loan is guaranteed by Fannie Mae or Freddie Mac then they might be able to refinance via the Making Home Affordable plan even though they're seriously under water.

[Joel]

Except for the whole personal responsibility thing, Old Limey might have a point.... It does sound like a mistake was made in taking on that much debt, but they should take the consequences rather than the lender.

[JimL]

Beyond the ethical/moral issues on the "walk-away" approach, there are risks in doing so. I was listening to a legal program the other day that indicated that the bank with the 2nd mortgage can come after you for walking away. State laws vary on the primary mortgage. The alternative is to arrange for a short sale.

With that said, here are my thoughts:

Priority #1 - Establish and emergency fund

Priority #2 - Establish a "baby fund"

Priority #3 - Eliminate 2nd mortgage

Note: Consider delaying the start of your family until you accomplish the first three

Priority #4 - Pay down the primary mortgage to a level that will allow you to refinance to a fixed loan (rates will eventually go up and kill you)

Priority #5 - Fully fund your retirement savings

[Ken]

1 - Fund an emergency fund of 6 months expenses
2 - Begin a savings account for baby expenses (500 a month for one year)
3 - Attack the second mortgage.
4 - Continue to fund your retirement accounts.

[bobsmith]

Forget saving. Spend like a college student with thier first credit card. That's what our government does.

[CB]

Even if I paid off some principal early, which I have, my payments stay the same. If I missed a monthly payment or whatever is the outside limit, the house would be in foreclosure.

I don't think pre-paying a mortgage is a safety net if one can't continue to pay the monthly amount until the loan is due (of course that could be a decade or more sooner, depending on terms).

[MasterPo]

MasterPo agrees with much of the above.

Paying debt down is nice but you need cash on hand.

[Travis D]

To anyone/everyone suggesting that he walk away from the house when they have the capability and income to afford the mortgage... shame on you. When we decide that personal responsibility is "inconvenient" and it is easier to walk away from a house that we could make payments on but since we're "upside-down" we'll just walk away - this is when the country is in trouble. Who do you think holds the loans on these houses? The banks have sold them off. Mortgage backed securities "hold" the loans and these are held by... YOUR 401-Ks and IRAs! So continue to give advice to people to walk away from their responsibilities, but don't question later why your own portfolio drops 40% in a given year.

[BillV]

@old limey: your comment surprises me. Not saying it's wrong; just that it suprises me.

To the poster, you have to live some where. do you like your place? Can you afford it? Do you like your 'hood? How are the schools?

Depending on your answers, you have no loss unless you sell now. If you really mean to stay 10 or more years, it does not matter what the value, of your home is now. It's worth less? so what. there are more qx's to answer, can you afford it for one. Your home is not an investment, but a place to live and raise a family. S*rew the current value. Live, enjoy, and save like heck. worry about the value in 10 or more years. Ten years ago smart people were saying the market would be at 30,000. You pay your money, you take your chances

who knows what the market will be in 10?

[Mike Hunt]

For everyone who is against walking away just because it's immoral, look to the big banks for your compass. Wells Fargo is walking away from commercial property on where it is underwater- if there is interest I will dig up a link.

Remember your contract between the bank and yourself is you pay the mortgage or they take the house. There is nothing in writing to my knowledge that you will try your best to keep paying regardless of the actual value to equity levels. You are obligated to do anything more than the contract states.

That said if the author of this post DOES decide to walk away you MUST see a qualified local attorney as if this is not done correctly you will be facing a long period of the potential for people to come after you.

Good luck!

-Mike

[Aks]

Walk away! There were some recent articles in wpost and nytimes questioning intelligence of homeowners sticking to a home which is worth less than the mortgage. You will be losing big money even if u stay there for next 20 years. Walk away, rent for a year or two and then buy another house. 2nd mortgage will have to be paid off no mtter though.

[Mark]

A few words on the morality of walking away: Many (perhaps most) underwater borrowers are crime victims. A massive fraud was committed, to build a large portfolio of mortgage-backed securities. Perhaps the true immorality was in the system that persuaded someone to get on the hook for $325K to occupy a home that was worth $200K?

If the mortgage companies had not made loans so easy to get, then less people would have had loans, house prices would not have ballooned and the bubble would not have developed. Economics 101 - Supply and Demand.

Many people with negative equity are only in that position because the mortgage industry conned them into it. It's easy to say that they were naive, but it is also easy to feel left out of the great American Dream and fall into these traps.

I have spent the majority of the last 5 years overseas, and since I have been back in the US, I have felt like I have to watch my wallet - I am continually being offered "deals", whether for a "free" security system, cable TV or a "low-priced" roof. Sometimes I have to search really hard to find the catch - and there is ALWAYS a catch. I can just imagine how someone less financially literate would struggle with this.

[Mark]

I just found this quote in an article in the Sunday New York Times by Richard Thaler - basically saying that in some states (non-recourse states) the lender can only take the home, and in others, they can come after you for repayment. He claims that in these non-recourse states, closing costs are higher to cover this risk to the lender. (In other words, you have aleady paid for the right to walk away!)

QUOTE FROM NYT:
“The morality argument is especially weak in a state like California or Arizona, where mortgages are so-called nonrecourse loans. That means the mortgage is secured by the home itself; in a default, the lender has no claim on a borrower’s other possessions. Nonrecourse mortgages may be viewed as financial transactions in which the borrower has the explicit option of giving the lender the keys to the house and walking away. Under these circumstances, deciding whether to default might be no more controversial than deciding whether to claim insurance after your house burns down.

In fact, borrowers in nonrecourse states pay extra for the right to default without recourse. In a report prepared for the Department of Housing and Urban Development, Susan Woodward, an economist, estimated that home buyers in such states paid an extra $800 in closing costs for each $100,000 they borrowed. These fees are not made explicit to the borrower, but if they were, more people might be willing to default, figuring that they had paid for the right to do so.”

[hc]

I agree with the sound financial advice listed above
1. EF 2. BABY 3. 2ND MORTGAGE & RETIREMENT

I think as consumers we all have a personal responsibility when making decisions that greatly impact our finances. We as a country seem to freely place blame on external factors for the current status of things in our own lives. No one forced this couple to walk in to the lender's office and finance 100% of their $329k home. Where is the accountability? If they were facing layoffs and can no longer afford this house or need to relocate that is a completely different scenario. It sounds like they are bearing the market downfall like every other homeowner with no sound reasons for walking away other than convenience.

Like with anything, they have a choice and a right, if they can rent for far below their mortgage and are happy with accepting a loss on this then so be it - more cash on hand is always good and the market is what it is.

I just think we all should be informed and held accountable for these decisions and stop passing the buck. The banks are there to give us as individuals the right to make "choices" and have opportunities, it is ultimately our responsibility to read between the lines and do our due diligence. It is far to easy to claim ignorance after...... we all suffer due to that attitude.

[Crystal]

Personal accountability people! This family isn't going to walk away or he would never have written the question, but just the fact that walking away was suggested makes me frustrated.

They make good money and took two loans with their eyes wide open. They have not suffered from a job loss or family emergency that lasted longer than their emergency fund would cover. They should pay off their loans.

Personal ethics and morals should dictate the decisions you make in life, whether or not the rest of the world has those ethics doesn't matter. The financial choices we make (like loans) will effect other people. Let's try to at least fake a sense of personal responsibility.

And for anybody who mentioned a bunch of excuses that don't make walking away wrong...those are excuses. You know it's wrong to borrow money and to default on the loan when you don't have to...it just sounds sickingly self-entitled.

Anyway, to the post, I agree with the mentioned plans:

1) Emergency Fund of at least 6 months of post-baby expenses
2) Fully fund retirement
3) Baby Fund
4) Pay off the house starting with the 2nd mortgage
5) Once all of those have been covered, prioritize your financial goals...you can start an Opportunity Fund for financial ops that pop up in life or start funding a college account for your kid...you'll have tons of options once your house is paid off.

Good luck!

[Old Limey]

The moral and ethical question of reneging on a loan has been an interesting subject throughout history.
If any of you have ever read Charles Dickens or other English writers of that period you would know about Debtor's Prisons - not a place that anyone would ever want to be. That's how debtors were dealt with in the old days. In those days there was also no welfare, food stamps, or unemployment insurance so impoverished people, and sometimes young widows, ended up in the Work House, another terrible fate.

I am neither a lawyer or a realtor but I did take a few real estate courses many years ago.
One thing I remember was that the laws pertaining to real estate debt instruments vary from state to state. In California we no longer have mortgages - we have Trust Deeds.
As I understand it with mortgages you aren't released from your responsibility by walking away but with Trust Deeds you are - a huge difference.

My parents were never able to afford to buy a home, as were most of the working class during their time, so it was never an issue with them. Personally I never missed a payment in my whole life on anything and now it's no longer an issue because I am debt free and wealthy.

As Mark pointed out very well the present problem was brought on by the actions of the realtors, mortgage brokers, mortgage lenders, and banks. In this Bubble there were plenty of Winners as well as all of the Losers. My son was able to buy two pieces of real estate during the Bubble and more than double his money on each one. It wasn't that he was some brilliant real estate investor - it was just that his timing happened to be perfect. Since he lived foolishly as a young single man & acquired lots of credit card debt he was compelled to declare bankruptcy at some point to wipe the slate clean. Soon after he married and they decided it was time to buy a home. Naturally his first loan application was rejected because of the bankruptcy, but then the realtor said, "Let's try again and put the home in your wife's name". My son said, "That's fine with me except that my wife doesn't work, has no income, and doesn't want to work because we want to have a child". The realtor replied, "That's OK, I will just make up some income for her when I fill out the application", i.e. submit a Liar Loan.
The loan was approved, the beautiful new house in Los Angeles was purchased for $200K and sold about 6 years later for $500K. The same procedure was used to buy a condo at the Mammoth Lakes Ski resort, which also doubled in value by the time he did a 1031 exchange into a ski condo that he owns free and clear today. He was lucky, today he, his wife and 9 year old daughter live, rent free, in a beautiful condo by the beach that my wife and I had no use for but didn't want to sell because it was fully depreciated and selling it would have resulted in a huge income tax liability. Meanwhile he became his company's top salesman and now, at age 46, has no debt and a net worth approaching $1M.

The last administration heavily promoted the idea of the "Ownership Society" - it was a seemingly great idea but they never anticipated the greed of the lenders, the issuance of liar loans, and all of the other greedy shenanigans that were perpetrated from small realtors all the way up to greedy institutions such as AIG and Goldman Sachs.

I wonder what the next Bubble will be.

[BillV]

@Crystal: You tell them lady! It's more about personal responsibility than morality. The poster needs to take a serious look about where he and his family will be and the long term consequences of walking away. It will be with him forever. Maybe, just maybe, walking away will be the best course in the mid term. But I strongly suggest that it should not be the first option. After all as you point out they have the income to pay for it.

Saying that Wells Fargo is doing it, doesn't make it a good financial choice for him. I repeat myself, theconsequence are different.

[Jim]

I'm not going to defend defaulting on a mortgage as a moral or ethical thing to do.

I'm not saying this couple should walk away, but it is an option for them to consider. Given their situation (as far as we know) it looks like they are in a good position to stay in the home and ride it out. Assuming they really do want to be in this home for 10+ years. But maybe theres more to the story and they might want to at least consider walking away.

At some point if we get into debt deep enough it really is best to 'throw in the towel'. This is why we have bankruptcy laws and things like non-recourse mortgages in the first place.

If you think its amoral to default on a loan then do you think bankruptcy is amoral in general? Should nobody ever go bankrupt ever or if they do are they somehow 'bad' people?
At what point is it OK to walk away from debts?
How deep of a hole do you have to be in before its justified to walk?
What if I'm very sick or lose my job or an earthquake destroys my business?

Where do we draw the line to declare debt 'too much' and when are the circumstances bad enough to justify defaulting?

These are meant as rhetorical questions. I don't know the 'right' answer to the questions myself. But I do think at some point people do have to look at debts seriously and realize they are in too deep of a hole and to climb out of it.

[Bethany]

No one has brought attention to the fact that he mentions that his first mortgage is INTEREST ONLY that is set to readjust in October. If that is the case, they may not be able to afford the monthly payments once they must pay on the principal. Depending on how much of an increase in payment we're talking about, the ethical debate over walking away might be all a moot point: the house is lost.

If foreclosure is inevitable, I would suggest keeping all other obligations current, not cashing out any retirement accounts, and paying the mortgage last (if you can't stomach not paying at all). It will take a year or more for the bank to foreclose - use that year to save as much as you can. Your credit will take a hit with the foreclosure, but you should be in an good position to rent a few years while you recover.

[Old Limey]

@Jim
I don't believe that morals and ethics have any relevancy in this situation. What is important is honesty, full disclosure, playing by the rules, and obeying all laws governing a particular transaction.

During the Jimmy Carter years we had widespread inflation and interest rates got up as high as 18% for CDs. At that time lending money appeared to be a better deal to me than investing in the stock market. I started investing heavily in limited partnerships that provided 1st. and 2nd. Trust Deeds to homeowners and apartment owners, this was before the days of widely available home equity loans. Before making a loan we would obtain an appraisal and obtain the amount of debt already on the property and calculate the borrower's equity in the home. We would then inspect the property and the neighborhood and if everything looked good we would make a loan with a maximum value of 70% of the owner's equity. In the property being discussed here we would'nt have even considered a loan because the borrower didn't have any equity.
The whole philosophy back then was that you didn't care about the morals, ethics, or financial condition of the borrower, all you cared about was the equity he had in the home.
I participated in a lot of loans, received monthly interest at rates between 14% and 18%, collected large late fees on occasion, and sometimes even a large prepayment penalty. We never had a single loan go into foreclosure because nobody gives up on a home when they have 30% equity and homes were appreciating all the time.
There was one loan to a builder that I remember well. It was a 1st. Trust Deed on a gorgeous home in a great area and the builder who owned it was on the verge of bankruptcy and being hounded by the IRS for back taxes. We were really hoping that we would end up with the home since we were the 1st. lender in line. To our dismay the IRS exercised their legal right to take the home for unpaid taxes, and we just got our money back and all accrued interest. In a good real estate market and on a well secured loan, lenders hope that the lender will send them back the keys and walk away but it never happens. Making real estate loans where the homeowner has little or no equity is madness and stupidity. In the case of these young homeowners, don't feel sorry for the lenders, they deserve whatever happens to them for making such terrible loans.

[Crystal]

Ethics play a part in EVERY situation in your life. If I based my personal ethics on what I could get away with legally, I wouldn't like myself and wouldn't expect anyone else to either.

If a person goes into a loan knowing the terms, they should do everything in their power to pay that loan back. I also think that every person should take it upon themselves to plan for situations like unemployment in a realistic way...6 month emergency funds before you take on hundreds of thousands of dollars of debt.

No, not all people who default on loans have a choice - extraordinary situations do happen. BUT, it is a matter of personal responsibility to have backup plans in place for normal situations like being unemployed for a few months or having a medical emergency. Things like that can be planned for and it shouldn't be too surprising when they happen since they happen to everyone all the time.

Most of the foreclosures in my area were due to people taking loans they could barely afford to start with. Some of them were due to people taking ARM's in hopes they could "flip" the house before the new rates took effect. That is risky and unethical behavior since they knew they would default if things didn't work as planned.

The banks didn't force these loans on people...we were pre-approved for $200,000 but we chose to use $91,200. Personal responsibility solves a bunch of problems. If we weren't sure we could pay it back, we would not have taken the loan. Why is that so hard to understand? Don't play risky games with other people's money.

Other people's unethical behavior does not excuse my own. A bank rep that is willing to skirt the rules is not a bank rep that I would want to work with.

[Kim]

I tend to agree with Old Limey. The reader seems to have everything going his way financially, except the house. The house will be an even bigger burden when his rate resets and when he goes to P&I. He is so far underwater. He will be throwing his money in a dark hole for years to come and still with no equity. That money could go toward securing a better financial future for his family.

Cutting his losses now could make a trememdous difference in their family's financial future in the long run. No one wants to default on their loan, but this may the be the best financial option. With the scores and scores of people doing the same thing - there will be tons of people with perfect credit except for one blip when they walked away from their house. I think lenders in years to come will be understanding. I have been working in commercial lending since the early 90's when we went through a real estate down cycle. Perfect credit with one blip due to a one time incident like a medical crisis, or one foreclosure was not uncommon. Many of these borrowers became valued customers and all futures loans to them were paid as agreed. One incident with a plausible explanation was not considered a huge obstacle. You may only run into problems with consumer loans that generally are not underwritten, but just based on credit score.

[Old Limey]

If high morals and personal ethics are so important for individuals why is that we don't hold coporations and government organizations to the same high standard?

Think back to ENRON as one of the worst examples and then all the option backdating scandals of other major corporations in recent years. Then how about the flagrant and incredibly risky behavior by companies such as Bear Stearns, Lehman Brothers, AIG, Fannie Mae, Freddie Mac, Countrywide Mortgage, Goldman Sachs, Bank of America and the 180 banks that have failed since the start of 2008.

Personally it makes me sick that we, the law abiding, living within our means, taxpayers of the USA, are facing unsustainable budget deficits for the rest of this decade and possibly on into the future trying to dig ourselves out of the gigantic mess caused by bad governance and corporate greed. I read a lot of expert opinions on world economics, and our President is correct that our deficits are unsustainable, the first country to fall is probably going to be Greece, others on life support are Ireland, Italy, Spain and Portugal.
It also saddens me deeply that I won't be passing on a better country to my grandchildren, as has happened for almost all prior generations.

[MikeS]

Just wanted to make a few points:

1. Current LIBOR rates are incredibly low. If the mortgage is pegged to the 1-Year Libor (as mine is) it would currently reset to an interest rate of about 3.10%. Not too shabby.

2. As far as morals and ethics, I can only control my behavior. I cannot control anyone else. I can control, to some extent, which companies I patronize. Such that if a company is acting in a behavior that I disagree with, I will take my business elsewhere. Can the individual walk-away? Legally, probably. Is it the right financial decision, possibly. But I don't agree that it is the ethical decision to make.

3. Old Limey, I find it interesting that you talked about how well your son did with the real estate, but didn't have a problem with him lying on his application. Just because the broker was willing to lie on the application, doesn't make it ok to do so.

Just my 2 cents.

[Crystal]

I do think ethics should be important to corporations and government organizations too...that starts on an individual basis.

I can't change how everyone behaves, but I can control how I behave. When people interact with me on a daily basis, I strive for good communication and friendliness. That rubs off on others...I've seen it happen. I will continue to live the way I'm proud of and I hope it rubs off on as many people as possible.*

*That sounded dirtier than intended. :-)

[Crystal]

I just read MikeS's response...diddo to all that. :-)

[Jim]

Crystal : "Don't play risky games with other people's money."

Isn't that exactly what the banks did? The banks bet on lending these people $325k with 0% down. That was a significant risk based on speculation. If the banks had been responsible they would have required a 20% down payment.

Why in this case should the individual bear ALL the burden of the real estate collapse and the bank get 100% of their money back even though the asset at stake lost so much?

What if the borrower went to the bank and offered to renegotiate the loan down to $260 and meet the bank 1/2 way?

[Troy]

I think there is discrepency with what exactly constitiutes moral or ethical violations.

Walking away from a mortgage is fulfilling the contract.

So is paying.

I do loans for a living. The note and Deed spell out two possibles options. Pay or don't pay. The bank agrees to two possible options as well. Payments or collateral.

Many of you are making a crystal clear situation fuzzy. You don't need to.

Defaulting on the payments is part of the contract. In fact a majority of the note and Deeds verbiage spells out EXACTLY the process for payment default.

This is precisely why loans have interest rates that are above 0%. That is the exact reason for interest. To compensate for the risk of default.

Default risk is baked into the contract. It is part of it. When a borrower defaults on the payments, they are not defaulting on the contract. Only a portion of it

Quite the contrary. The contract then states upon payment default the lender siezes the collateral. So they do.

So pay or not pay, you are still honoring the contract, just different PARTS of the contract.

None of this is immoral or unethical.

What would be unethical is if you stopped payments and were allowed to KEEP the house anyway. Of if you made timely payments and the lender foreclosed anyway. That is immoral and unethical.

When you DO NOT follow the terms...ALL THE TERMS of the contract is when you run into ethical issues. That is not the situation here.

As far as walking. I would do whatever was withing my legal rights to place my family in the best most secure financial situation in the future. In fact, I do that every day, and so should everyone.

AndFinally, I would never intentionally accellerate paying DOWN your mortgage. I am all for paying it OFF, but that is a one time event. $0 balance.

Paying it down with extra payments is foolish. It is transferring risk from the lender to yourself. Never transfer risk to yourself unless you have to.

Right now the OP lender has all the risk. The borrower has virtually none. The borrow has almost no money at stake. The bank has it all. Keep it that way. Save up additional extra principal payments in a savings account or something. Then, when it gets large enough to pay off the loan in full, pay it off in full. Not until your loan is paid OFF is risk removed. Until then is is simple being transferrred the wrong way.

[Crystal]

The banks made risky investments and lost too. I don't think they should have been bailed out. I also think 20% downpayments should be required to get a mortgage. BUT, no one had to take $325k loans with 0% down. That was a choice they made. The crash was definitely caused by a conglomeration of self-entitled businesses and individuals.

I think the banks should either renegotiate with the borrowers or get stuck with houses that aren't worth as much as the loan. If I were a bank, I'd work the numbers and go with the most profitable option.

As a borrower, I bought a home at a certain price...I thought it was worth $114,000 when I bought it, so I bought it for $114,000. I'll finish paying off my $91,200 loan in 8 or less years and own the house I wanted. It's sad when an investment depreciates, but it isn't basis to dump the loan and move on. When I finance a car, I don't get to renegotiate the loan every time the car depreciates. People just assume that houses will appreciate, but that's not how pricing works.

The crash happened, the banks got bailed out, and it will probably happen again. It sucks, but I can only control how I behave and hope that helps society as a whole. If I buy another house, I will continue to make sure that I can meet the terms we agree on and go on with my day.

[Jim]

Troy makes a good argument against paying making extra principal payments. If something goes wrong then they could lose any extra money they put into the principal.

Consider this example: Lets say this family stays in this home with the intention of living there forever. They decide to pay off the mortgage and start making extra payments worth $25,000 a year. In 4 years they've paid off the 2nd loan and paid a litte towards the primary loan. Then the wife has 2nd kid and the father loses his job. Now they have zero income and no kids. They run through their savings in half a year and are out of money. They can't pay the mortgage at all and they lose the house to foreclosure. The house has gone up a bit and is worth maybe $220k but they still owe about that much on the mortgage.

They pumped $100k into the house and still end up losing the house and that extra $100k along with it.

Or they could sit on that $100k and put it into their bank account. Then if something happens like a job loss they still have $100k in the bank and a house that isn't worth anything.

[Jim]

When I said : "Now they have zero income and no kids" I meant zero income and 2 kids.

[Crystal]

I don't think you save as much in interest by just waiting until you can pay the house off in full. I haven't worked the math, but it seems to me that by paying DOWN the loan, you decrease the total amount of interest you will pay. You would have to be able to guarantee the same rate of return on where you stash the extra money as you could save by paying down the loan quicker, right?

I wouldn't want to put that money in something like stock due to risk and I can only make about 2% with CD's. With interest rates as low as they are now, saving 5.375% by paying down our mortgage seems like a good investment. Of course, our house is worth more than is owed...does that change this thought process?

[Jim]

Crystal, yes the difference is that you have equity and they do not.

The risk is that they might lose their home due to some unforeseen tragedy, job loss or other sequence of events. Its not highly likely they'd lose the house but it could happen. If they pay extra principal yet are still underwater and lose their home then they lose that extra principal.

They don't want to pump all their extra money into an upside down mortgage leaving themselves cash poor.

[Mark]

@Crystal: I love reading the regular comments on this blog by you and Old Limey!

You said: "no one had to take $325k loans with 0% down. That was a choice they made."

May I add -
"No mortgage company had to lend out $325K with 0% down. That was a choice they made".

"No mortgage company had to hire appraisers to over-appraise $200K homes at $325K. That was a choice they made".

"No ratings agency had to rate sub-prime mortgages as if they were prime. That was a choice they made".

"No mortgage insurer (AIG) had to insure a $325K loan with 0% down. That was a choice they made".

"No investor had to skip due diligence and buy a slice of a $325K loan with 0% down. That was a choice they made".

I suspect that the mortgage industry made these loans with ridiculous terms fully anticipating that one of two things would happen:
1. The buyer would refinance later so they could collect even more fees and interest.
2. Foreclose and make money off the poor souls who couldn't afford the payment resets.

Unfortunately, these banks chose to gamble and LOST - Foreclosure doesn't look so profitable now. The buyers were not the real dummies. The financial wizards were.

@Crytal again: You are absolutely right mathematically when you say that you save more by paying down than by saving the money in CDs etc. until you ahve enough to pay off.

Troy and Jim are saying that you have not considered risk and opportunity cost correctly.

Suppose your home was destroyed by an act of war or nuclear disaster and hence homeowners insurance did not pay. Would you rather have your money in a savings account or invested in your paid-off house? There are a host of other less extreme events that might occur.

I have a fixed rate of 4.625% on a fresh (December 2009) 30 year mortgage, and I am planning to pay off as slowly as possible (i.e., NO ADDITIONAL PRINCIPAL). I don't expect a nuclear disaster any time soon, but I do expect inflation in the next 30 years as the US struggles with large deficits. This loan is my inflation hedge.

[JimL]

Unfortunately, I see a number of comments on here where people are trying to justify or provide "legality" towards walking away from a debt. We try to put the blame on someone/something else like to "bad banks". In the end, others pay the price. The price for borrowing increases to others, home defaults drive prices lower for neighboring properties, etc. What ever happened to personal responsibility? I am with Crystal on this one.

[Old Limey]

This topic has generated far more postings than most, I bet FMF is smiling because the more activity this blog generates, the more advertising revenue it generates, and the more he is able to give to very worthwhile charities.

When we bought our first home in 1963 unless you were a Veteran and qualified for a CalVet loan there was no way you could get a loan with $0 down. We went for a conventional 30 year loan at 4% that required a 20% downpayment. That provided a nice cushion for the lender, a modest monthly payment for us and everyone was happy.

Bubbles seem to be unavoidable. The market crash of '29 was brought about by very low margin rates and lack of regulations in the market. It resulted in the formation of the SEC and high margin rates but the economy didn't really recover until much later when America entered WWII and the economy took off.

The Internet Bubble was another classic bubble, remember all the talk drummed up about "Old Fashioned Brick & Mortar stores" that were soon to become obsolete as we all gradually shifted to Internet purchases. People believed that until the Bubble burst because many of the websites turned out to have poor business models and couldn't compete in many areas.

When that Bubble burst and the stockmarket went into a lengthy decline people turned to real estate as a way of speculating. Home prices started shooting up and everyone was very happy for a while. Many started using the new found wealth provided by their home equity as a Piggy Bank to pay for college education, nice vacations, fancy cars and many other things they couldn't afford with just their paycheck. I can remember calculating the future value of my home at its present rate of price appreciation and realizing that this was unsustainable and couldn't last.

The other huge change in recent history has been the outsourcing of most American products to countries with the lowest labor rates. It's great for consumers to have low prices but when it's at the expense of people's jobs we can now see what the downward spiral has produced ==> high unemployment ==> debt ridden people unable to make their payments ==> mass foreclosures ==> collapse of home values.
Spirals like this are hard to reverse and this one would have put us in a Depression had it not been for massive government spending that some economists such as Nobel Laureate and Princeton professor Paul Krugman say has not been nearly massive enough.

@JimL
Read your contract - if you live in one of the fourteen states that use Trust Deeds the property is the collateral for the debt and it is your perfect right to terminate the contract at any time by vacating the property and giving the keys to the lender. They already hold title to the property, you don't receive the title until the loan is fully paid off, only then does the property belong to you.

[BillV]

This has been a most interesting posting. I have never been convinced of the advantage of paying off your mortgage early but most everyone seemed to think it is a good idea.(I'm not not talking about paying the whole thing off) thanks Troy.

I also liked the reminder about both parts of the contract. Follow the contract and there are no ethical violations. I still think Crystal has a point though--personal reponsibility is worth something in my book.

Good job FMF

[MikeS]

I thought about this some more on the drive home. I think for me, it boils down to one thing, I made a promise to pay the money back that I borrowed. By walking away from my mortgage, while completely ok in the eyes of the contract and the law, it wouldn't be moral in my book because of that promise. Maybe I'm just naive, but I think this country would be a lot better off if people would keep their promises. I don't expect it to happen anytime soon, but I will do my part to make my little corner of the world a better place. Other people are free to do as they choose and I will have to live with consequences of those actions, be it with higher interest rates when I borrow, depressed housing prices or higher taxes because the government is bailing out anyone with their hand out. Such is life.

[Old Limey]

@MikeS
I understand completely where you are coming from and in a perfect world it's a great ideal.
However look at it from this point of view.
Huge lenders such as Banks and Mortgage companies have long lives and deep pockets, and as we have now found out some are even considered by the government as too big to fail.
As an individual, a husband, and a father I have a limited lifespan, and a limited time to earn and save money so that I could always be self supporting. The most important responsibility I ever faced was that of providing food, shelter, and security for my wife and three children. To that end I would never resort to breaking the law, however, if facing a choice such as the one we have all been discussing, without any doubt or hesitation whatsoever my family comes first and my decision would be to take whatever action was in the best interests of my family and NOT what was in the best interests of a Bank.

[Crystal]

I'm not saying people should let their families suffer in order to pay their mortgage. I'm saying that people should take mortgages they can afford while providing for their families. It's not that I have the interests of the bank at heart, it's that whole personal standards thing again. :-)

[Troy]

The thing is contracts are broken all the time. Every day large and small.

And walking away from your mortgage is not breaking the contract. It simply enforces the 2nd provision of that contract.

Even so, look at other common contracts. Divorce is breaking a contract. Early termination of a cell phone contract is breaking a contract. Breaking a lease is breaking a contract. Backing out of a home purchase under contract is....you get my point.

Speeding is breaking a contract. Going over the mileage limit on a leased vehicle, Being late for work, missing a payment of any type... the list goes on.

People break contracts all the time, or if not breaking them they engage in the second "default" clause of those contracts. Are any of my examples immoral or unethical. Or are they simply part of life.

Alot of talk here about personal responsibility. Standards. Promises. But real responsibility sometimes requires difficult decisions, and walking many times is the most responsible thing to do.

It doesn't mean you don't keep your word or promises. Or you are somehow untrustworthy.

It means you treat the situation as it is. A financial decision that is the most responsible for the individual making it. It doesn't matter what others do or think, but what is right for the individual homeowner, and what is right is defined many different ways.

Starving your family so you can "honor" your promise? Eliminating health insurance or cutting back on safety for your kids...are these all the "right" decisions so you can keep your ethical promise?

OR...If you knew that by walking away from your mortgage you could get a fresh start, save money for your kids education, finally move to a better location, follw your dreams, teach your kids about choices for the greater good would you make that sacrifice. Would you sacrifice your word with the bank to keep it with your family?

[Troy]

And to further discuss the "prepayment" option requires understanding risk.

Risk is the most important component of personal finance. More than expected return, interest rates, leverage, arbitrage, taxes or anything else.

Everything in finance is related to risk, yet so few discuss it or really understand it.

Insurance is the transfer of risk. When you buy a homeowners policy, you are paying to transfer the risk to the insurer.

When you borrow you are paying a risk premim in the form of interest. When you invest, you are earning a return based on risk.

So take risk into account first. On everything.

When you payoff debts, don't rank them by interest rate or balance or payment amount or alphabetically. Base it on risk. Pay off the riskiest debts first. Like the IRS, or your employer, or family members, etc.

Same with prepaying a mortgage. When you have little equity the bank assumes most of the risk, and they charge you for it in interest. By paying DOWN your loan you are transferring that default risk, which decreases with each payment, but not enjoying a commensurate lower risk premium in the form of a lower interest rate. Your interest rate stays the same yet your risk of default decreases. Nice for the bank. Not so much for you.

Money is pretty simple. Addition and subtraction. Everything else is noise.

Look at Limey. $10 million+ dollar net worth. Mostly liquid. Has a house, two paid for older cars and his massive investment portfolio. Keeps it simple. And I guarantee you he accounts for risk with all things financial.