|
May 5, 2003
"What happens if the housing bubble
bursts? Will I lose my house if I owe more on it than it is worth? If I take out
an ARM or balloon loan, will I be able to refinance them when they come
due?"
If you continue to pay your mortgage on time,
you don�t lose your home when its value drops below the mortgage balance.
While your ability to refinance may be compromised, you don�t need to
refinance an adjustable rate mortgage (ARM). Balloon mortgages could be trouble,
though.
A bubble is a marked price increase buoyed by
expectations that prices will continue to rise. In a bubble, underlying value
becomes irrelevant, you buy because you believe you will be able to resell at a
profit. Once that expectation comes into serious question, the bubble bursts, as
it did with internet stocks in 2000.
Markets in common stock are vulnerable to
bubbles because it is easy and cheap to buy and sell. Sales commissions are
small and the cost of holding stock is negligible.
The house market, in contrast, is much less
vulnerable to bubbles because the cost of buying in order to resell is very
high. A "round trip" in a home (purchase and sale) costs 10% of the
property value or more in sales commissions alone. To this must be added the
cost of holding the home between the purchase and sale dates, including
financing costs, property taxes, and insurance. Carrying costs are especially
steep if you aren�t living in the house.
This doesn�t mean that the home market is
completely immune to expectations of rising prices. If this belief is
widespread, some consumers will purchase earlier than they would have otherwise,
some will opt for more expensive houses, and some of those trading up will elect
to rent out their existing houses rather than sell them. These and other such
actions can create a mini-bubble in the home market, which can burst like any
other bubble.
But since the bubble doesn�t get very big,
the fall-out won�t be severe. Prices may decline modestly for a few years,
before starting to rise again. The fundamentals underpinning this market are so
strong that it would take a major depression, such as the one we had in the
1930s, to cause a prolonged and severe decline in home prices. And that is not
in the cards.
This may be scant consolation to those who
purchase houses with little down, who find themselves owing more than their
house is worth. However, your lender can�t take your house away from you when
this happens, nor would he want to.
In situations where the mortgage balance
exceeds home value, lenders worry about owners who "send they keys to the
lender". Such owners shift the loss to the lender, sacrificing their house
and their credit rating. Most owners, however, elect to gut it out until the
market turns in their favor.
When equity in the home has disappeared, the
possibility of a cost-reducing refinancing usually disappears with it. However,
rate adjustments on ARMs are not refinancings. The ARM rate adjustment occurs on
the existing instrument, not a new one, and it is affected only by what happens
to interest rates. It is not affected in any way by what happens to home value.
While balloon loans are refinanced at
the end of their term, generally 5 or 7 years, the lender commits to refinance
at that time and can�t beg off because the property value has declined. The
refinance commitment, however, is hedged in several other respects that could
cause a problem for the borrower who has no equity in his house.
First, the lender need not refinance if the
borrower has been late on a single payment in the preceding year. That is scary.
Second, the refinance commitment is at the lender�s current rate. The borrower
with no equity will be obliged to accept that rate, whatever it may be, because
he has no place else to go. Third, if that rate is 5% or more above the old
rate, the lender need not refinance.
The likelihood of rates being 5% higher while
property values are lower is very low. Generally, property values decline in a
weak economy and interest rates rise in a strong economy. Nonetheless, it could
happen.
If I were buying a house with a small down
payment in a neighborhood that had been rapidly appreciating, I would avoid
financing it with a balloon loan. But an ARM is OK.
Copyright Jack Guttentag 2003
| 
