Real Estate Exit Strategy: What If There’s No Way Out?

One of the great wonders of modern life is the ability to borrow — and borrow and borrow and, well, you get the idea.

I always tell folks there is no shortage of either lenders or loans, the real question concerns borrower preferences. If a borrower is sufficiently “motivated” then there are always loans to be had. Of course, when there is sufficient motivation there are also borrowers to be had, a thought which brings us to the subject of loan-to-value ratios.

This may sound like a real snoozer, but LTV is a subject which may soon haunt lots of people. Across the country there are now incidental reports of falling home prices, especially in the upper brackets. “Price changes” now seem to be more common in listing notices, and by “price changes” no one means sellers are asking more.

If we are seeing a pause in the remarkable series of price increases seen during the past few years, and if in some cases we are seeing actual declines, then the game changes. Millions of people who bought at or near full price may suddenly find that they own a property which is worth no more and perhaps less than what they paid.

This is not really much of a practical concern for those who stay put, but what about those who move? If you paid $500,000 for a home that is now worth $485,000 can you sell?

In this example the price drop is just 3 percent, not a lot in the context of the purchase price but enough to sink two groups of buyers, those who purchased with little down and those who bought with high-risk financing.

Over the years the amount down required to buy a home has fallen dramatically. If you were a buyer in the 1970s your financing choices were largely limited to conventional loans with 20 percent down, FHA mortgages with 5 percent down and VA financing with nothing down.

Today downpayment requirements are non-existent. You can buy with nothing down and you can even buy with 110 or 125 LTV loans — in other words, you can borrow more than the house is worth, enough to finance both the purchase and closing costs — plus maybe something extra.

Loony loans with little or nothing down are a philosophical worry when home prices are rising — and a real disaster when property values are stagnant or falling.

Go back to that $500,000 home, the one now worth $485,000. Guess what? It’s can’t be sold for $485,000, at least not in the sense of getting a check for that amount at closing.

Sell a property for $485,000 and you have a starting point from which to deduct taxes, marketing expenses and settlement expenses. You may wind up with $460,000 or maybe less.

The difference between a $500,000 debt — the sale price of our model property purchased with nothing down — and a $460,000 net selling value is minus $40,000. Do sellers have such money? Some do — but many who bought with nothing down or extra-jumbo loans cannot bring such cash to closing. And that $500,000 purchase price does not include settlement costs to buy, perhaps another $10,000 or $12,000.

In some jurisdictions the ability of lenders to recover purchase-money loan losses is limited to the value of the property. In effect, the seller cannot be sued by the lender for a loss on the mortgage when the property is sold. However, such protection does not exist in most states, does not apply to properties which have been refinanced and does not apply to home equity loans.

In effect, many who bought at the top of the market with little or nothing down cannot sell because if they sell they will be bankrupt even if home prices fall just a touch. The good news, in a sense, is that by not selling such folks hold down supply and thus keep prices up.

But the other problem is that many who have purchased with no money down, with interest-only financing, with stated-income (no-tell) loans, with adjustable-rate mortgages and with option payment financing also cannot stay.

Many loans today allow buyers to acquire homes with small monthly payments — at least at first. But the point comes when those microscopic up-front payments soon require full-blown monthly remittances.

A recent letter said I could borrow $500,000 and pay just $1,608 per month. That’s $19,296 a year in loan costs, a payment rate equal to 3.8 percent — at least at first.

However, rate caps may result in “deferred” interest. In other words, that initial monthly payment may not be the amount actually needed to reduce the debt. If the real interest rate is 4.7 percent, then the required interest-only payment would be $1,958 per month. With interest-only payments the loan is not getting any smaller, but at least it’s not getting any bigger.

You might think the loan with the low payment rate would save the borrower $350 a month ($1,958 less $1,608). However, if the missing interest payment is added to the loan balance, and if interest rates do not change, then at the end of five years another $21,000 in monthly shortfalls would have been added to the loan. Of course, interest rates might rise and each monthly addition to the principal balance would also increase the interest cost.

In general, let’s say that after five years the debt is now $521,000 and that the interest rate increases to 6 percent — a minimal interest level for most of the past 50 years. The loan now has 25 years remaining and the monthly payment will be $3,356.80 for principal and interest. That’s more than twice $1,608.

The prevailing theory seems to be that higher monthly costs are not a problem because one can just sell the underlying property. But such thinking assumes that property values will rise — and that is not guaranteed. If property values merely stay the same large numbers of people in the next few years will be both unable to make monthly payments and unable to sell for enough to pay off growing mortgage debt.
Published originally by Realty Times on November 1, 2005 and posted with permission.

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