High Risk Mortgages -- Was 2006 A Wakeup Call?

2006 will be known in the annals of real estate as the year of the slump. Home values fell in many markets around the country -- in some cases, significantly. This negative appreciation will, without a doubt, have a lasting effect on borrowers with high-risk mortgages. But will the hardships facing current homeowners with these types of loans be enough of a wakeup to new homebuyers thinking about similar financing? Owning your own home is part of the American Dream but sometimes choosing the wrong type of financing can turn that dream into a nightmare.

For the past half-decade, the housing market has sizzled. Appreciation has been solid and predictable. During those hot years, many home buyers turned to higher risk mortgages for a variety of reasons. Some buyers chose interest-only loans in order to afford bigger homes. Yet others financed homes up to 100% in order to get in on the action, even when savings were low or non-existent. While the market was cooking along and appreciation was strong, many were able to justify these and even riskier loans. However, when 2006 hit, things changed.

In 2006, many homes throughout the United States actually lost value. For those homeowners that financed at or near 100% shortly before the slump, this often meant that they now owed more than the home was actually worth -- in some cases, much more. The average American moves every 5-7 years, most often due to changes in job, position or career. In normal market conditions with normal appreciation, it takes, on average, 2-3 years of positive appreciation for a home to build up enough equity to offset the costs of selling. The loss of equity or even just the loss of positive appreciation experienced in 2006 will force homeowners to wait longer before moving or face the strong possibility that they might owe more on the home than can be recovered with a sale. In some markets where value lost was severe -- 25-50% -- homeowners may not break even for a decade or more if the market turns around and begins to appreciate at a steady rate again.

For many homeowners, waiting to move just isn’t an option. Job relocation, family responsibilities or even financial hardship (as well as many other situations) can force a move. If that happens before enough equity can build in the home to offset closing costs, more and more homeowners may choose foreclosure over bringing money to the closing table. It’s no surprise that many financial experts are predicting a large spike in foreclosures over the next decade.

How and why has foreclosure become such a viable option? In conventional 80% LTV (loan-to-value) financing, the buyer puts 20% of the value of the home down and finances the remaining 80%. This type of loan creates a cushion to guard against depreciation or the necessity of a quicker-than-expected move. Because homeowners that obtain 80% LTV financing have a full 20% equity invested in the home, foreclosure is likely not the best option. Usually a good portion of that 20% can be recovered with a traditional sale -- even immediately after purchase.

However, today, a buyer putting the full 80% or more down on a home is a rarity. With median home values exceeding $200,000, buyers -- especially first-time homebuyers -- often don’t have $40,000 in savings to put down on a home. Due to the ease, flexibility and prevalence of today’s loan programs, many homeowners are choosing the risk of financing at a much higher loan-to-value ratio just to be able to get into the game. The elimination of the 20% cushion means that if homeowners get into a pinch, foreclosure is a much more likely proposition. And why not? I know plenty of lenders that will work with buyers only a year out of foreclosure. Let’s face it: the penalties for foreclosure and bankruptcy are not as daunting and prohibitive has they once were.

Other than the homeowners themselves, the lender is the first to bear the brunt of a loan default -- especially in 100% LTV situations. This includes months of lost mortgage payments, legal fees and ultimately, the likely need to try to sell a defaulted home that might not even be worth the money that was loaned to purchase it. Some lenders may be able to write this off as an expense of doing business -- on occasion. But if the rates of foreclosure go up as predicted, I’m not naive enough to believe that those costs won’t be passed on to us -- the collective buying public -- in the form of additional processing fees or higher rates. Ultimately “we” will have to pay for the growing number of defaults.

2006 is now real estate history -- will the realization that home values can and have dropped significantly in a short period of time serve as a wakeup for homebuyers to not take risky mortgages for granted? The short-term answer is, No, it likely won’t. As long as these mortgages are easy to get and the penalties for foreclosure, light, many buyers will still choose to gamble that 2006 won’t happen again until their home appreciates and creates a cushion. It will take more than a few stories of hardship to sway the buying masses. The ultimate question is: will lending and real estate institutions step in and intervene to save buyers from themselves. As lenders begin to feel the pinch of their own programs over the next few years, we may see a move away from high-risk mortgages and towards better counseling and a more in-depth qualifying process. This will be a welcome trend and will help create more informed and capable homeowners. While it won’t completely prevent buyers from getting in over their heads, it might get them to think twice before making a purchase with a loan that doesn’t provide any viable escape option other than foreclosure.