I’ve always dreamed of owning my own home. Where I’m from, just about everyone does! It’s hard for me to imagine having an apartment and paying rent rather than enjoying a whole house and paying a mortgage. I always understood owning a house to be the smarter financial decision of those two options, too.
I was pretty young back when the 2008 crash happened, but I know that a couple of my family members ended up in some rough spots with their mortgages. I think some of them just stopped paying and walked away, even though they could afford it, and I never understood that. Why not just pay off the house and sell it? Now that I’m in college, I’m trying to understand a bit more about how all of this works. I don’t want to ask the family members themselves, so I’m asking the experts instead!
On the surface, mortgages are pretty simple things. They’re loans that allow the borrower(s) to buy a house. The house is collateral for the loan, so if the borrowers don’t pay back the bank, the bank can foreclose on the house. That’s it–but an in-depth look reveals some more complications.
It is possible to end up in a situation like the one you describe, in which deciding to let the bank foreclose actually makes the most sense. To understand, we need to talk about a few more things related to mortgages and homes.
First, mortgages have an interest rate–the lender is being paid back more than the amount of the initial loan, of course, because that is how lenders make money. To get an idea of how this works, you can look at this interest rate calculator for home loans. There are also fees for missing payments and other built-in rules to a mortgage.
Second, the real estate market can go up–but it can also go down. In 2007 and 2008, it did the latter. Home values fell dramatically in those years, so much so that the housing and mortgage crash led to a worldwide recession and a 57.8% drop in the value of the S&P 500. In fact, median home prices didn’t reach pre-crisis levels again until 2016.
Let’s imagine for a moment, then, that you purchased a home in 2006 and took out a mortgage for its value. If you missed some payments, you’d owe even more in late fees and interest. And then, with the crash, you might see the value of your home decline. This doesn’t mean your home has gotten any worse, of course, but with fewer people looking to buy it, supply and demand would dictate that it is no longer as valuable.
Through this combination of factors, you might find that you owe more in mortgage payments than your property is actually worth. And this is despite the fact that you have already made a down payment and made some regular mortgage payments! It’s a rough situation. We call this being underwater with a mortgage. While it’s terrible for your credit to allow your lender to foreclose on your home, it may be the best option for some people when the situation is truly dire.
The good news, though, is that it’s a lot tougher to end up underwater in a healthy housing market than it was in 2008. Home values are on the rise–the median is up 6.9% since last year–and if you take out a mortgage that you can afford, you’ll be positioned to ride out short-term blows to the market. Meanwhile, you can make improvements to your home that affect its value. Replacing windows and updating other features, experts say, can reduce your energy costs, modernize your home, and improve its value to future buyers. Similarly, dedicated homeowners should invest in maintenance measures: regular re-painting, HVAC maintenance, and a wealth of other little chores can make a real difference in the long-term value of your home.
“There have been few things in my life which have had a more genial effect on my mind than the possession of a piece of land.” — Harriet Martineau
John Regan is a former Director of Sales for equity research.