What's The Cause Of The Massive Increase In Foreclosure Buying And Will It Persist? - Part I

Skyrocketing Foreclosures- Buying by Investors

It's a fact that the number of real estate foreclosures is skyrocketing. All over the US Real estate investors are buying foreclosure homes and homes in preforeclosure at firesale prices. A quick scan of the legal part of your newspaper will reveal the large list of properties scheduled for the foreclosure auction. Statistics indicate that over 1% of the today's homeowners will be behind on their payments or this year will face mortgage default and foreclosure. Just think, almost every neighborhood in this country will have 2-3 homeowners not being able to make their house payments. So it's not surprising that some savvy homebuyers with cash, and real estate investors make low offers for buying foreclosures and preforeclosure homes.

Lenders Lure Homebuyers and Pay the Consequences

This is bad news for the homeowners and bad news for the banks and institutional lenders who are looking at billions of dollars of loans that they're not getting interest payments for. It is of course, great news for investors buying foreclosures, because when the supply is high, the prices go down. Banks are even taking less that what they're owed for the loan by accepting short sales offered by investors and at foreclosure auctions (for more information on short sales see resource box).

So why is this happening? Here's 3 acronyms that tell the story:

ARM 's - Adjustable Rate Mortgage
HELOC's - Home Equity Line of Credit
80/20 - 80/20 no down payment loan

ARM 's are the chief culprit. Those who are not familiar with these types of mortgages, the way they work is that when the loan is first issued there is a very low (below market) interest rate. Then after a set period (from 1 - 10 years), the interest rate adjusts upward as much as 2% based on an interest index. The rate then adjusts annually by as much as 2% until the cap is reached which can be 10-12%, although caps can be in the 12-16% range.

Of course

Adjustable Rate Mortgage Lures Unsuspecting Buyers

However, this apparent good fortune for the new home purchasers was often just a foreclosure waiting to happen. A day of reckoning was coming, and these homeowners would have no idea what hit them.

Here's an example of what started happening and is continuing to happen today. Let's say Jim & Sue Tenants have a fairly low income of about $2000/month. A general lending rule of thumb is that your mortgage monthly debt should be no more than 30% of your gross income. So based on this, Jim & Sue could afford a %HOUSE% monthly debt of about $650/mo.

Now let's say they could get an ARM with a 1% starting percentage value and a cap of 12%. They could qualify for a $200,000 loan with monthly debts of $643/mo. And let's also suppose the lender does not escrow the taxes or insurance. Typical taxes & insurance let's estimate to be about $2400 or $200/month. (By the way, the following scenario will play out the same, no matter what the starting percentage is).

Jim & Sue move into their new home, purchase a bunch of furniture on their credit cards, a new TV, and stereo, and some window treatments, etc. After about 6 months Sue gets pregnant. The tax bill comes due in September, and Jim and Sue are in a bit of shock. They haven't been putting away money for taxes, and it takes most of their meager savings to pay the bill.

Payment Trouble Leads to Unavoidable Foreclosure Default

Then around November, the mortgage company sends them a letter informing them that the value is adjusting upward by 2% and their monthly debt starting January will be $843 per month-a $200 increase. With their credit card debt, a new baby on the way and monthly living expenses, they're really living on the edge. When their next tax bill comes due-Jim decides the county is just going to have to wait for it's money. (In reality what will happen is that the county will put a lien for back taxes on the property and sell that lien at a tax sale auction. The real estate investors purchasing the tax lien or tax certificate (in many states) will eventually have the right to foreclose if they're not paid the back taxes and interest. Essentially buying the foreclosure for the cost of the tax lien!).

Then in November of that year, they get another letter informing them of another increase in their interest value-this time to 5% (still pretty low), and this raises their monthly mortgage monthly debt to $1074/mo - a $230 increase!

Now, Jim & Sue are in over their heads. Come January, they send in the old monthly debt amount. The bank doesn't accept it and considers them in default. They think they only owe the difference-in fact, the bank considers it as if they hadn't made any monthly debt at all. After several months, they get a foreclosure warning letter.

At this point Jim and Sue may consider selling their %HOUSE%. If they live in a rapidly appreciating market, they may be able to get out by the skin of their teeth. In most areas, after only a year or 2, most homes have not appreciated enough to sell quickly. With a realtor commission and accepting a discount from the purchaser, they'd have to come out of pocket to go through with the sale-money they don't have.

So depending on their state, unless an investor steps in, buying the foreclosure by negotiating a short sale with the lender, the property will be sold at auction on the courthouse steps according to state foreclosure laws.

In the next part, I'll discuss the insidious nature of Home Equity Loans for the unwary borrower.

SUMMARY

The rate of foreclosures is at an all time high, and many real estate investors are buying foreclosures, looking for big discounts by negotiating short sales with lenders and buying foreclosures at the courthouse steps. The reason for the high rate of foreclosures are lending practices such as ARM's (adjustable rate mortgages), HELOC's (Home Equity Lines of Credit) and 80/20 (nothing down loans) that allow home buyers to borrow more than they can afford. In part I, how ARM's create this problem is analyzed. In parts 2 and 3, the consequences of home equity loans, and no money down loans are analyzed.

KEYWORDS

Foreclosure buying, real estate investor, investing, short sales