Saturday, June 27, 2009

Loan Mod Vs Walking away

I get asked on a regular basis about what I think of walking away from a house. 10 or 15 years years ago I had a different opinion than I have now. Back then I thought it was a cop-out, a terrible thing to do. I don't think that any more. Now I'm much more of a realist. My opinion is that you should do what ever is best for you and your family (as long as it's legal and walking away is in most cases).

From a financial standpoint, in today's market, walking away is going to be a much better choice than a loan mod for most families in the IE. A loan mod might make more sense if the home in question is only slightly underwater but that's hardly the case with most IE homes purchased in the last 6 or 7 years.

In the last real estate bust I stayed put while many of my friends walked away. I was never very far underwater though. However I would have liked to have moved in the mid 90's but couldn't because of still being underwater. I was trapped when some great opportunities presented themselves and unable to take advantage of them. Several of my friends that were foreclosed on in the early 90's did not have that problem. They rented for a few years, rebuilt their credit, saved up and when those opportunity arose they were able to buy. The end result is that they all ended up far better off than me 5 or 6 years later.

In this cycle I know a few people that are walking away, I know a couple of families doing a loan mod and I know one family that even managed to pull off a short sale. I can guarantee the families doing the loan mods will come out of this worse of than the others.

Let's take a look at what's likely to happen by doing a comparison. We will assume the market is bottoming, it will stay there for 5 years and then start going up at a normal 3% per year. I will assume interest rates remain low but not as low as today (let's say 7% in 5 years). I will assume each bought a home for $500k that's now worth $250k and will be worth the same in 5 years. For ease of comparison we will assume tax and insurance is $600/mo

Family 1, has a 500k ARM and wants to do a loan mod. They get a mod locking the rate at 4% for 5 years. Payments are $2400 plus tax and insurance for a total of around $3000 per month. In 5 years they will have paid $144,000 with little of that being principal. At the end of five years they will still owe $452k and the payments will reset to 7% taking it to $3007/mo, plus tax and insurance for a total of roughly 3600/mo. At the end of 5 years, family # 1 is still $200k upside down, trapped and unable to sell, and unless their income rose they still might be facing foreclosure.

Family #2 also has a $500k loan on a house worth $250k. They however choose to send the keys to the bank and move into a recently purchased foreclosure rental. They rent a similar home for $1800/mo. The net difference in total monthly payments between family 1 and family 2 is roughly $1200/mo. Family 2 saves this $1200/mo and after 5 years has $72k in the bank. After 5 years their credit is good and they can once again buy. They purchase a home similar to family one's home for $250k using 20% down (50K), they finance $200k at 7% for monthly payment of $1350 plus tax and insurance or roughly $1900/mo.

After 5 years both families own similar homes:

Family 1 owes $450k and has a payment of $3600/mo.

Family 2 owes $200k and has a payment of $1900/mo. That's $1700/mo less and they owe $250k less on the home. If they were to apply that extra $1700 to their monthly payments they would pay off the home in about 7 years!!

This comparison is not assuming the worst case. Homes could fall much farther than 50%, interest rates could go much higher than 7%. This is a simplistic comparison but it is probably fairly accurate. It gives a chilling indication of what the banks and the government are trying to do to the unsuspecting homeowners. Many of these people really do think the government and the banks are trying to "help them" stay in their homes. That's just not the case. The government and banks are simply trying to avoid a collapse of the banks. Helping the home owner is the last thing on their minds.

Most people are stunned when they do the math. I've given advice to quite a few people and most of them do see the light. The really amazing thing is that a couple of them still pursued loan mods. Their reasons for doing it were that they really thought the prices would come back. In both cases when I asked they said "they thought in 5 years that the prices would recover and they would be able to sell". Me thinks not....


OSA said...

Great post. You say there are no consequences. In what cases it is not legal to walk away. You lose your credit but they can't come after you for anything else?

Dan said...

Very good post. I didn't verify your numbers, but they certainly seem reasonable and my gut agrees. Of course, I'm not sure I want too many people to recognize this reality. I'm probably better off by them becoming home debtors for the next 10 years

Adrian Smith said...

I still don't get why 40 year loan modifications aren't in style. Many people around me seem perfectly content remaining in perpetual debt (credit cards, new cars, mortgages), and tacking on an extra 10 years to a house seemingly wouldn't seem like much of a big deal if it meant lower monthly payments, which is what many people seem to focus on anyhow.

Adrian Smith said...

"seemingly wouldn't seem"? That's horrible.

golfer_X said...

Going from a 30 year to a 40 year really does not lower the payment much. On a 300k loan at 6% the payment only drops $150/mo going to a 40 year loan.

OSA, you need to check and see if your loan is a non-recourse loan. In some cases the banks could pursue a debtor for the unpaid balance depending on the loan. It's very, very, rare for them to do this however. There can also be tax consequences so it's a good idea to run it past a good lawyer prior to bailing. I know quite a few guys that have bailed and none of them had any tax or bank problems though.

Adrian Smith said...

I must have been bad at math last night, for some reason I thought it would be more substantial than that. How about 50 or 60 year loans then? Might as well pass on the mortgage to your kids, maybe teach them some responsibility in the process. Or, you know, just accept the fact that you bought at the wrong time and suck it up. I'm only half-joking about either scenario.

rays97runner said...

Loan Mod make no sense unless the banks are willing to adjust the priciple-Practically unheard of. Seems to me that would be a better option than the hassle of foreclosing and eventually getting way less anyways. It wouldnt really be fair to let all these people who bought houses they couldnt afford off the hook like that but still seems to be the best options for everyone. I am a little bitter that all these people bought houses they couldnt afford and drove the market so high that I couldnt afford a house until recently even though I made a good salary. I hate to see these people rewarded for doing the wrong thing, but adjusting principles closer to market value would be good for the banks and the market.

golfer_X said...

Just for schitz and giggles I did some back of the napkin calcs on one of the two properties where they decided to go for a loan mod. They paid $650k for their house in Hemet (yes that's right HEMET). It's now worth about $250k (that's what the REOs in the area are selling for). I figured an average appreciation of 3% and calculated how long it would take to reach $650k again. The result was 32 years! It will probably be longer since homes are still not appreciating. I expect another 5 or more years before that happens. So the time frame is probably going to be closer to 40 years barring hyperinflation or another bubble.

Grace said...

Great Blog, I agree with you.Please keep at your good work, I would come back often.

Empire Realty said...

These are the numbers that the consumers have to deal with in making a decision about walking. In 90% of the homes bought from 2001 with little or no down in So. Cal. it makes better financial sense to walk.

Ken said...

Could you imagine the inventory of homes that would be produced if even 50% of the people that are underwater just walked away from their homes as you suggested? Talk about a tsunami!!!

Allison said...

I agree with you X, I used to think walking away was horrible. Now, I understand.

I'm not in the situation myself since the one home we own is in Utah and is slightly, if at all, underwater. But if I bought a house in Hemet for $650k like your friends, no question in my mind I would walk away.

Kelly - Diversified said...

Good information as long as homeowners understand what walking away does to their credit, etc. But many aren't going to have much of a choice as they will need to file bankruptcy in order to qualify for the mod. So the real questions is bankruptcy, foreclosure, mod?

The banks need to serious consider reducing principle as they do with a short sale. My question is why isn't anyone pushing them to do so.

Oldtimer said...

X, I believe the recent bubble in IE home prices versus values has no recent precedent. Maybe the gold rush in the 1840s in Northern California? So what was sensible in the recent past may not be sensible today.

$650K in Hemet?! Did that house come with a vineyard that generates $50K in annual income? I'm sorry but Hemet is close to nothing in terms of jobs, and has for the last 30 years been an agricultural area and a low cost retirement community.

Before that, I believe it was simply a remote agricultural area like the Imperial Valley today.

David said...

The problem with loan modifications is they fail to address the major reason why people are defaulting.

Job losses have reached such a high rate that has not been observed in the last couple of decades.

Foreclosure rates rise with unemployment levels as many homeowners are also affected if they are not able to earn money for long periods of time.

The unfortunate fact is that borrowers still default on their payments as they are still not sure of a fat pay check in the coming months either.

I came across a really interesting article on this topic.
Housing market and unemployment

golfer_X said...

Job losses are certainly a part of why people default but it's not the main reason. The primary reason is negative equity. Once people realize they are underwater by $100k or more, many of them make the decision to bail. It's just a numbers game for many people (the smarter ones anyway).

Mark said...

Mortgage lenders are no different than pawn shop lenders. They both lend against collateral, be it a title to property or a gold watch.

If a pawn shop lends too much money, and the pawn shop customer does not meet the terms to reclaim the collateral (be it a watch, or title to a property), it's the pawn shops own damn fault.

Some people think the pawn shop should to whine to the goverment, and be able to have the government use it's force to extract a "deficiency judgment".

They want pawn shops to have risk free profit from the labor-free lending of money, the for force of government backing the up.


Ken said...

One problem with your analysis, you forgot to reduce the owner's $3000 monthly costs for tax savings. Assuming that $2400 of the amount is deductible then the savings might be $800 per month so the difference isn't $1200 per month but $400. They will only have $24,000 for a down.
Ken, CPA

OSA said...

what do you do when you have my situation. put down 20% of hard earned money (80K) and am still underwater by 150K. How do you walk away? I just have to wait it out or my grandkids have to wait it out. Most of those that are over 100K under probably put nothing down so it is easy to walk away. For me, not so much

golfer_X said...

I figure the tax savings would be offset by the added expenses of owning. As a renter you don't pay for maintenance, HOAs and often times yard or pool services. Maintenance costs average between 2% to 4% of the purchase price. We should use 250k, and not the bubble purchase price, With that amount your maintenance costs average between $5k and $10k. That seems high but if you factor in the size of the home it might be reasonable. My place is 1800 s/f and I spend about $4k per year on average. Some years it's $2k, last year it was closer to $10k. The tax savings would be about 6K per year (depending on your tax bracket). So it's nearly a wash.

golfer_X said...

OSA, You can lose $80k or lose $230K (plus interest). The $80k is gone, you should not even factor that into the equation.

Run the numbers using todays information.

What you owe, and what your payments are.
Decide for yourself when you think the price of your home will recover. Do you think it will recover in 10 years, 20 years, 40 years?
Run the numbers and see how you come out.

If I were $150k underwater I'd be walking. I'd stop making payments, save up for as long as I could and when the bank foreclosed I'd rent. You could probably get 1/2 your $80k back by living in your house for free for a year or more.

Jesse said...

OSA, I know someone in the same exact situation. In their case they put down almost 150k. They are using the same logic to stay put. I can try to understand how you feel and I think I kinda understand. The way the market is right now, depending on where you live, the prices might drop a little or a lot! BUt the main thing is they are gonna fall. I totally agree with X on this one. Try hangin in there for free and try one of those loan mod B.S to extend your stay. Banks are not foreclosing on people right now! They can't afford to without sending the economy back in to shock. Save up as much as you can. Plan the whole thing and It won't feel like a "foreclosure". I mean you will feel in control if you initiate it. Its going to hurt but you are setting yourself for more hurt if you continue to stay underwater with such an amount. Its a continuous stress! Prices are not going anywhere. Use this to your advantage and may be you will end up with some healthy equity in a few years after you buy your new house. In the end you know your employment situation better than anybody else. So you think about it. Just my two cents. Good luck with whatever you decide to do.

Michelle said...

Osa, play the loan mod game and you will be able to live there for about 9 months to a year. when they finally denied you or you tell them its unfavorable, switch to a short sale. i heard with a short sale you will be able to buy in 2-3 years. A lot, I mean A LOT, of people are using this tactic. Good luck.

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Luanne said...

I just don't want to get into the calculations as I am little shaky in them. But yeah I would like to comment on Loan modification and suggest that people should take utmost care while choosing a loan modification attorney or firm because it matters the most for entire Loan modification process.
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