Matt Frost noted that there were “strange reproductive politics implicit in the comments” on the foreclosure email post. This is fascinating, from a commenter: “I finally lost my sympathy when they decided to have a baby without their financial situation being resolved.”
You know who else was born at a moment where the parents didn’t have access to stable housing? Jesus. But I’ll stick to the maths.
I suppose that comment hinges on what you mean by financial situation being resolved. If it means waiting to have a baby until, say, all your student loans are paid off, sorry to tell you but on behalf on my generation the piping will probably have gone dry by the time the last of those are paid off. I assume it means that life, moving to new jobs, starting new careers, etc. should be put on hold until underwater mortgages start to clear. How long is that going to take?
Let’s assume that there’s an option value in being above water in your mortgage, if only because you can sell it without having to go into your pocket for additional payments. You’d have to do that for the massive transaction and closing costs in the exercise we are about to do, so we’ll assume that’s even.
I’m also fascinated by this post at calculated risk. They reproduce this graph:
Noting: “Strategic default on the part of the owner occupier becomes more likely at such high levels of negative equity….The default rate increases sharply for homeowners with more than 20% negative equity.”
This got me thinking: what does the payment schedule look like for someone who is 20% negative equity? How long will you be underwater, given reasonable market conditions?
Let’s take a reasonable suggestion of market conditions. This, as everything that is at the rortybomb blog, is not to be taken as financial advice. Let’s say inflation is 2% in the near future. According to Shiller’s data, the real gain to housing is .26% compounded annually. (Huge thanks to Richard Serlin for thoughtful help with me thinking through these examples.) So let’s say the nominal value of your home increasing year to year is 2.26%.
Let’s also say your mortgage is 30 years, and that the interest rate on it is 6%. As a reminder, LTV means Loan-To-Value, or the ratio with the mortgage amount divided by the property amount. Many people bought at the top of the bubble that when prices crashed, so their mortgage turned out to be a lot higher than what the property is worth.
One key to remember is that, as always with mortgages, the first mortgage payment you make is almost all interest, and the last mortgage payment you make is almost all principal. I am going to assume that this mortgage is three years into the payment cycle when we calculate the LTV.
Example One: Average
Here’s a chart that takes this example and graphs the LTV versus the years it takes for a mortgage to become above water, to have the principal of the mortgage equal the house value through growth of the value of the property and paying off the principal (R code available if interested):
So if you are 10% underwater, it will take around 29 months, or around 2 and a half years, until you own a small piece of your home. If you are 30%, it will take around 76 months, or around 6 and a half years. For those with an LTV of 120, they have 54 months – they will pay for the first small piece of their home around August 2014.
Example Two: Interval
Now that’s an average case scenario. Let’s plot it again with a good case and a bad case, to give us an interval. How best to do it? I’m going to assume a 4% yearly nominal growth for the good case scenario – split that between inflation and property value growth however you’d like. For the worst case, I am going to assume the nominal value of the house decreases 2% for 2 years, and then goes back to increasing 2.25% year after year. Here is that graph:
The higher line is the bad case scenario – keeping LTV the same, it means more time until you are above water. Here the range is 20 to 54 months for an LTV of 110 and 55 to 97 months for an LTV of 130. For an LTV of 120, where the defaults accelerate, looking out you’d see an interval of 39 to 77 months, or a timeframe between April, 2013 and June, 2016, when you can be above water. How’s that for uncertainty?
As you can see, the marginal effect of principal increases never really decreases – it’s always equally bad to add more principal, and equally good to remove some, in terms of getting above water. This is why mortgage modifications that add principal are terrible, which I’ll discuss in the next post.
Edit: Original code accidently added one to the value of months for all LTV; changed in text and charts. Sorry, I blame the lack of sunlight and too much time at a screen.
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Who was it that said “Men who bought stock in the summer of 1929 will see their entire adult lives pass before they break even again”? This should work well moving forward if we replace “stock” and “1929” with the updated quantities.
And that’s the thing – if you are a random dude, if you lost all your life savings betting on pets.com, that sucks. But it’s over in a day since you (usually) aren’t leveraged, and for the personal market, usually they grab you on collateral if you are. Hedge funds are another thing. But at the end of the day when pets.com goes bankrupt, there you are. There’s no “can I move to another city to pursue a job?” liability.
Being underwater like this is a whole other story. Hedge funds just collapse. They aren’t carrying around this massive backlog of debt with them for a decade.
I really wonder what the housing market will look like in 10 years.
Great post Mike.
One thing that really stands out to me here is that one of the claims for the mortgage interest rate deduction is that it encourages home ownership. But a key thing is that home ownership is really when you stably own your home, not when the bank could easily take it if everything doesn’t go just right. You’re really a home owner when it’s solid. When you have a substantial degree of equity, and you can afford the monthly payments even if something goes pretty wrong, like a spouse losing a job. And something going wrong is far more likely today than it was a generation ago. You’re really really a homeowner when the mortgage is paid to zero — something that should be an important goal to achieve relatively quickly for any family that has settled into one place for a while.
Given this, the mortgage interest rate deduction is, in some ways, anti- home ownership because it encourages people to take out more debt on their homes – to, in that way, own their homes less.
So often I hear people (and students – I teach personal finance at the University of Arizona) say that they want a long term mortgage, or to take out home equity loans, to take advantage of the mortgage interest deduction. This doesn’t really make sense if, like most people, you should be investing some substantial portion of your money in safe assets like U.S. government bonds, because paying off your mortgage faster is like putting your money into a U.S. government bonds, but even with forgoing the mortgage interest deduction, it still pays higher interest than U.S. government bonds do (see this comment of mine for details: https://rortybomb.wordpress.com/2009/12/10/questionable-investment-ideas/#comment-3159).
But the point is, it gets people thinking this way, that it makes sense to borrow more, and longer term, and to not pay off their mortgage faster, and it gets home equity loan providers advertising about how savvy it is to “unlock your home equity”. It really discourages people from paying off their homes faster, from taking shorter mortgages, from not taking out equity destroying home equity loans.
In other words, in this way, it hurts the level of true home ownership.
One idea that would remedy this is to instead of having a deduction for interest, we have a subsidy, a co-contribution, for the down payment. For example, for every dollar of downpayment the government adds, say, 25 cents (up to, say, 30% of the median home price), and you get half of that money after staying in the home for five years, and 10% more every year after that for the next five. And it must be your principle residence that you live in, and other rules to prevent gaming.
I thought it was Galbraith, as it sounds Galbraithian (From “the Great Crash, 1929), but it’s actually some guy names Richard Salsman
Salsman wrote an article with the most objectivist title ever:
Altruism: The Moral Root of the Financial Crisis
Oh, no, Jesus’ family had access to “stable” housing (ba-dum-bump-ching!)
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