There is a new trend in some areas that have been especially hard hit during the past 4 years - people who are current on their mortgages walking away and letting the bank take back their house.  In the early 1980s this phenomenon was happening in Houston, TX, where we lived at the time, because home prices dropped all over the city and surrounding communities and people who were unable to sell their homes for what they owed simply walked away.  Some neighborhoods looked like Phoenix and Florida do today with foreclosure after foreclosure lining the streets.  Here is a link to a recent article from Realtor.com about the risks in doing this.

I was looking at information for a client on a home listed in our MLS and realized this home and seller were representational of the worst case situations that have been happening in the past few years.

They bought their home in 1998 for a great price, enjoyed having it appreciate to a current tax valuation $116,000 more than they paid in 1998, and then drained it of equity in 2002 and then again in 2006 by taking out large 1st and 2nd loans.  I don’t know the reason they did this, but it is very sad.  Sometimes people lose their job.  Sometimes they have huge medical bills to pay off.  Sometimes they use the money for other investments.  And sometimes they just treat their home as an ATM and the money ends up wasted on depreciating cars, boats, furniture, and just stuff.  And when the market changes, they are stuck and end up in foreclosure because they can no longer afford their payment.

In this case, the owner borrowed what the house was worth and did it not once, but twice.  And they didn’t use just a single mortgage, they used both a 1st and 2nd loan each time.  Remember my last post about easy money?  They were put at risk by risky loans.  I wish I knew what their story is.  Why would they do this to themselves?  The refinance in 2006 was at a variable rate over 1.5% higher than their 1998 rate.  And what was wrong with their 2002 loans that they would refinance and accept such a high rate in 2006?  Was their 2002 rate even higher?  Were their 2002 loans even riskier types of loans they were trying to get out from under?  Did they just want another $28,000 out of the house that they got by refinancing in 2006?  Why did they trust the lender who put them into these loans?  Did they realize they were putting themselves at risk?  Did they care?  Was it out of desperation?

Their 1998 rate was  fixed and they put 5% down.  They did everything right when they bought the house, but then 4 years later, everything seemed to start going wrong.  They ended up filing for foreclosure in 2008, actually managed to get a loan modification, and then went back into foreclosure in 2009.  Which, by the way, is not an uncommon occurrence.

The sad thing is that if they had stuck with their original loan, by fall of 2008 they would have paid it down by over $23,000 and with over $100,000 in appreciation, they could have sold in 2008 and walked away with cash in their pockets.  Their loan to value ratio would have been only 54%.  They would have owned 46% of their home 10 years after buying it!  Even if they had taken equity out to update the home, they still should have had plenty of cash when they sold.  A very sad case indeed.  And now an opportunity for someone else who buys their foreclosure.  Watch for posts in February about my free consumer seminars to help you avoid being one of these sad cases and instead be a story of real estate success.

First, let me share a little history lesson.  The change in the markets the past few years is now affecting what people are buying when they do buy a home.  During the roaring 90s when the dot com industry rose, people had a lot of extra cash in their pockets and built homes to reflect their desires.  Showy, big, extravagant homes dotted (that is a pun ) the landscape, especially in California.  Then the dot com bubble burst starting in 2000 and the market changed.  Investments in the stock market tied to technology went poof and bank accounts dwindled.  Real estate then became the go-to investment arena and we all know what happened.  Real estate prices escalated until 2006.  In markets like CA, FL, AZ, and Las Vegas, prices were surging 30-40% per year and those who were actually awake during that time realized what goes up must come down.  I personally could not believe that interest only loans were being used by consumers to purchase the home they would be living in.  Interest only loans are a strategic product used by real estate investors to manage cash flow.  I don’t think that description applies to most of our neighbors.  So what does all this have to do with smaller homes?

Just think how different the real estate market and our economy would be today if we had foregone the speculation of the past decade.  Did you know 1 in 4 homes was sold as an investment during the go-go years?  That’s 25%.  Do you think that had an impact on pricing?  Absolutely.  Just like tulip bulbs in Holland centuries ago.  We Americans went around with blinders on because getting money was so easy and we didn’t want to believe it could end.  But just like the dot com bubble, it was an upside down pyramid and collapsed under it’s own weight.  We ran out of buyers who could buy at such frothy prices.  Fortunately, in some markets such as Colorado Springs, we had more steady increases in prices and never saw huge increases, so most homeowners can weather the current market.  But even here prices have dropped about 20% on average over the past 3 years and people who bought at the height of the market are underwater unless they had a large down payment or have been making extra principal payments since they bought their home.  If they can stay put, they’ll be okay.  If they have to sell, they have a problem unless they can bring cash to closing.  For some, hardship will allow them to qualify for a short sale to avoid foreclosure.  Sadly, others will lose their homes.

So back to my question.  What would the market be like if the housing market had been steady instead of the scenario we did have?  First off, not as many people would own homes or if they did, they would own smaller homes than they purchased because they wouldn’t have based their decision on an expectation that their home was going to appreciate in the double digits every year and make them rich.  Home ownership DOES make people rich, but it is a slow steady process that lasts a lifetime.  The other thing we would have seen is smaller homes because they would be more affordable.  In some places, like California and Hawaii, they’ve had to keep home sizes smaller in general because land is so expensive.  If speculators hadn’t driven up prices buying properties with loans that required no verification of income or assets, more people would still be in their homes because they would have been given those loans based on more realistic requirements.  Hind sight is always 20-20, and looking into the past shows us a process that was totally out of control.

Fortunately, our economy provides the answers and we will dig ourselves out of this mess.  Without buyers who can or will pay inflated prices, home sellers have had to reduce prices in order to sell.  Many people who would like to sell have kept their homes off the market for now, reducing inventory, which will help with recovery.  The market is winding down, although in some places, it definitely crashed.  At some point we will reach equilibrium.  We are getting closer, although there are still more foreclosed homes coming to the market that will keep prices down for the next few years.  As prices have come down, people who didn’t want to or couldn’t buy when prices were high, are now finding that homes are affordable.  The rate of affordability has increased.  Builders will build smaller homes to entice first time buyers and seniors who are downsizing.  The other good thing that has happened is that people have started saving again and are being more cautious about buying.  Loans aren’t as easy to get and people have to jump through hoops to prove they can pay their mortgage in order to get a loan.  Many people will wait until they feel more secure in their work or feel they will be in the house long enough for buying to make sense.  But more people who didn’t think they could ever afford to buy, can now find homes within their means.  And ultimately we will help the environment as green technologies become more prevalent in building and remodeling and energy efficiency becomes more important.

If we keep the recent market lesson fresh in our minds, what has happened can prove to be a good thing because it is changing how people view money.  Perhaps individually people will remember and not allow themselves to be drawn into craziness in the future.  New homes built will be smaller so that builders can keep prices where buyers can afford to buy.  Condo owners will ultimately be helped as people discover that is an affordable option in not so affordable markets.  As baby boomers retire they will still want 2nd homes and that will once again help the Florida, Arizona, and condo markets recover.  Some baby boomers will retire to smaller, more affordable communities and will help the economies of those areas where their spending will create more jobs.  First time home buyers have a fantastic opportunity right now to get into a home at lower prices and amazingly low interest rates.  Even when the $8000 tax credit ends, homes will still be affordable.  But that still doesn’t mean everyone should buy.  It still needs to be a careful decision.

For those who can’t buy yet, investors are buying foreclosure and short sale homes and renting them out, so renters will find more choices available to them.  Investors will be part of the solution as well.  So there is light at the end of the tunnel.  Now is the perfect time to put money aside and plan to one day be a homeowner or get that 2nd home or move up to a bigger home.  With planning they are all great choices.  If you are in a position to act now, congratulations!  This will prove to be one of the greatest opportunities of the 21st century.