Peter Boockvar, Chief Investment Officer at Bleakley Advisory Group, says he feels bad for people who bought homes in the past year. Appearing on CNBC News, Boockvar in no way suggested that the economy is about to nose-dive. Rather, the investment expert spoke with compassion about those likely to be hurt most when and if housing prices correct.
According to Boockvar, it’s those who can least afford the financial hit who are likely to experience loss. Let’s say a buyer hoping to take advantage of historically low interest rates jumped into the market late last year. While the national increase in home prices has hovered around 15%, imagine that this home buyer got lucky and bought in a city where prices were only up 10%. So, putting 5% down on the house, the buyer moved into a property worth 10% more than it was the year before. So far, so good.
Here’s where things get sticky. If home prices correct, and the value of the home buyer’s property suddenly reverts to its pre-pandemic level, it is immediately worth 10% less than they paid for it. The homebuyer only put 5% down, and so is “underwater” — they owe more on the house than it’s worth.
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Disadvantages of being underwater
Once a homeowner owes more on a property than it is worth, there can be several issues, including the following.
Inability to refinance
Lenders will not allow a homeowner with no equity in a property to refinance. They worry that a homeowner has no “skin in the game,” and is more likely to walk away from the mortgage. Plus, no lender wants to loan more on a home than it’s worth.
No access to home equity
A homeowner with equity in a house knows it’s possible to borrow money against the property to cover the cost of an emergency, pay off high-interest debt, or make improvements. Without home equity, those options disappear.
To learn how expensive being underwater can be, let’s imagine that a homeowner owes 5% more than the property is worth, but must sell due to illness or a job transfer. It could look something like this:
- The homeowner owes $200,000 on the mortgage.
- Since home values have dropped, the house is now worth around $190,000.
- The homeowner asks $195,000 for the property, but doesn’t get any takers. The ultimate sale price is $190,000.
- Between Realtor fees and closing costs, it takes $17,100 to sell (9%).
- The homeowner must also bring $10,000 to the closing table to make up the difference between how much they’re getting for the house and how much they still owe, plus Realtor fees and closing costs. So it takes a total of $27,100 to get out from under the mortgage.
Being underwater on a mortgage can be devastating for a homeowner who can’t easily come up with the money to bring to the closing table.
Stay the course if possible
There is a close tie between an underwater mortgage and foreclosure — and perhaps that’s natural. It’s tough to pay more for a house than it’s worth. But as with most financial matters, it’s all about making the best long-term financial decision.
Long-term, the homeowner can eventually build equity in the house, speeding up the process by paying extra toward the mortgage principal each month or making one extra mortgage payment a year. History shows that home values are likely to rebuild steadily over time. Rather than suffer from the idea that they’re paying too much today, a homeowner can benefit by looking down the road and imagining how nice building equity will be. And while they get there, they can still deduct part of the mortgage interest on their taxes.
Even if a homeowner needs a roommate to help them cover the mortgage, it almost always makes more sense to fulfill the promises made to the mortgage lender than it does to get out early. Time is the great healer when it comes to rebuilding equity, and remembering that the situation has a long-term solution may prevent a homeowner from walking away from home and mortgage.
Walking away from a mortgage can disrupt a person’s financial life for years. For example, if walking away leads to foreclosure (which it almost certainly will), the homeowner’s credit score can drop by 100 points or more. Suddenly, a person who had a credit score of 740 is dealing with a score of 640 or less. That makes it more challenging to qualify for other types of credit — including credit cards, personal loans, and auto loans — and makes snagging a loan more expensive. A foreclosure also stays on credit reports for seven years, and that can impact everything, from getting a security clearance at work to renting an apartment.
If a financial situation becomes messier than expected, that doesn’t mean it’s impossible. Would it be disappointing for a new homeowner to end up with less equity than they hoped? Absolutely. But they still own a home, and can still work toward building the equity that will help them feel financially secure.