Thursday, January 21, 2010

The Debate on Walking Away From Your Mortgage

Media outlets this month have trotted out a series of experts to explain why it’s a terrible idea to abandon your home mortgage. Yet other experts say it’s a smart thing to do in some situations.

I couldn’t help noticing, though, that most of the experts who say that you should never abandon a home mortgage live around cities such as New York and San Francisco — big cities where staying put wouldn’t severely limit a person’s career options.

The fact is, though, that most people don’t live in such big cities, and the advice coming from there may not apply to people who live elsewhere.

First of all, it is important to understand that for many borrowers, the question is not whether they will abandon their mortgages, but when. If mortgage payments are more than 45 percent of pre-tax income, or will be after an upcoming mortgage rate reset, and the mortgage has more than two or three years to run, then it’s almost certain that the money will run out before the mortgage does. If, at the same time, the amount owed on the mortgage is considerably more than the value of the real estate, simply selling the property to pay off the mortgage is not an option. In this circumstance, when you know you can’t afford your home, the best time to get out is right away. Now, while you still have some money left and may be in a position to bargain with the lender. It will do less damage to your credit history this way than if you wait until the money runs out, and that damage will happen sooner, giving you more time to recover. If you can negotiate with the lender to get out of your house, it will cost you and the lender less in the end. Some people are waiting for real estate values to improve before they make this move, but that could be a big mistake — in most places in the United States, real estate values could fall another 15 percent before they level off, and it could be years before they recover to current levels — five years in some places, 50 years in others.

The other common scenario is the worker whose career is stuck because there are no better jobs available near home. If there is a profoundly better job offer elsewhere, or if there simply aren’t jobs anymore in your town, you really have little choice but to pack up and go, whether you can sell your house or not. A worker who gives up career advancement because of a bad mortgage situation could be giving up more than a million dollars in net lifetime income — but more importantly, giving up the chance to make a much bigger difference in the world. Work is ultimately what creates economic value, so it doesn’t make sense to ask anyone to sacrifice work just for the sake of a financial instrument, if this happens at enormous financial cost to themselves.

Of course, for people who work in New York, there is a good chance that none of this applies. Moving is hard work, no matter how good you are at it, so walking away from your suburban home doesn’t make sense if the only rationale is to reduce your monthly payments — and this means most people are better off continuing to make the mortgage payments. Evicting yourself from your own home when you don’t need to is not a financial strategy.

It helps to put the situation in perspective when you realize that about half of the people who are making payments on their mortgage owe more than the real estate is worth. It’s not a bizarre situation affecting just a few people. Realistically, though, these homeowners won’t stay put forever — only for an average of about five years, until work eventually requires them to move. Five years of mortgage payments may not lead to any increase in home equity in places where real estate values have not yet leveled off, so the financial problem won’t go away.

But this also means that foreclosures and short sales will remain high throughout the 2010s. Whenever someone who owes more on the mortgage than the house is worth has to move out, the lenders have to get involved, often at a loss, and the real estate market is affected. When you look at it this way, the people in banking who fantasize that the industry will somehow get the money out of the borrowers are deluding themselves. Here is another way to look at it. Suppose all these homeowners were to just stay in their homes till they died. Many would die still owing more than the house was worth, and the high mortgage payments would mean they would die with few other assets. Private mortgage insurance might cover the deficit, but the insurance industry does not have the financial strength to bail out the banking industry on this kind of nationwide scale. So that is not a solution either.

Before the mortgage crisis hit, I think many people did not realize how much of the real estate in the United States was owned by the banks. When we look at the situation now, with banks effectively owning more than half of the buildings in the country, it’s easy to say that that’s too much real estate risk for the banking sector. The rules of banking need to be changed to somewhat discourage banks from real estate loans in order to reduce the real estate risk on the banking sector as a whole.