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....