Drowned themselves
The most common reason that sellers are underwater now is not because of their initial mortgage. It is because they kept borrowing against the bubble-level equity of their house. Some did it to improve the house with a new kitchen, put on an addition, upgrade some of the systems, or just for good-quality maintenance. Others floated their vacations, cars or paid college bills. Some hedged their periods of unemployment or underemployment with their home equity loans.
When the bubble began to deflate, they found themselves stuck in their homes and in their mortgages. If they are lucky, they still have the income to pay the mortgage and keep the house. What they don’t have is the cash to leave the house.
The cash?
Here’s a rough case in point to show how owners can be underwater without being slammed by large-scale depreciation. I chose a middle-class example, because the example of people who bought with no money down at tippy-top peak is just too obvious. Those buyers had not equity to begin with.
Instead, I also used a town where the deflation has been relatively small, compared to most of Massachusetts and tiny compared to the rest of the country. I used a steady 5 percent loan rate, even though these owners would have started higher and refinanced down through the time period I am describing:
J and J bought a smallish house is Lexington in 1996 for $250,000. They added an addition in 2000 for $100,000. Today, they are still sitting pretty. They can still sell that house for $600,000 or more and walk away with a profit.
Here's how the the water rose:
But suppose that J and J had two children. Both got into private colleges. Because the house was worth $700,000 in 2005, the Js decided to cover the $200,000 in college bills on home equity. It looked like a great deal; the HELOC (Home Equity Line of Credit) was at 3 percent and the college loans were at 7 percent or higher. A no-brainer. They still had plenty of equity, since they had a $700,000 house.
If the Js bought their house in 1998. Then their smallish house would have cost $350,000. Their debt would be $257,000 $205,500 on the first mortgage, plus $79,000, plus $180,000. That’s $516,000 $464,000. They can still sell it and come out with cash in their pocket.
(added detail: $350,000 mortgage with 20 percent down creates a $280,000 loan. After paying for 13 years, they still owe about $205,500. Then add the balance on the loan for the addition in 2000. There is $79,000 left on that loan. Then add the $200,000 college loan against equity, which has a balance of $180,000. After correcting my error, that is a balance of $464,500.)
Once we get to 2000 as their purchase date, they are hosed. With a $400,000 original price tag, the first mortgage debt is now $315,000, $252,000 plus the other $259,000 brings the mortgage debt to $574,000 $511,000. Now the Js will lose some of their down-payment equity in a brokered sale. If they go for-sale-by owner, they will come out with a little cash.
(added detail: $400,000 mortgage with 20 percent down creates a $320,000 loan. After paying for 11 years, they still owe about $252,000. Then add the balance on the loan for the addition in 2000. There is $79,000 left on that loan. Then add the $200,000 college loan against equity, which has a balance of $180,000. $79,000 + $180,000 = $259,000. After correcting my error, that is a balance of $511,000. $252,000 + $259,000 = $511,000.)
Anyone buying from 2000 on, who also borrowed against equity could be get themselves into this situation. Many are. Those make up a chunk of the sellers who are holding on, waiting for the market to recover.
Are you a seller who is holding out because of your equity position? Are you underwater from your initial purchase mortgage, or from secondary borrowing?
Cue the chorus of bears…
I apologize for mis-reading the tables when I calculated the remaining debt on the primary mortgages of these examples. They were corrected shortly after publication.
