Mar012007

Financially Conservative Home Financing

prey_for_banksIn my first post, I said I was financially conservative. What does that mean with respect to financing a home purchase? It occurred to me that exotic financing terms are not exotic anymore. Interest-only, adjustable rates, and negative amortization have become so ubiquitous that nobody seems to remember why 30-year fixed-rate mortgages are used (or were used, they aren’t common in OC anymore). That is the focus of this post.

To be financially conservative is to be risk adverse. A fixed-rate conventionally-amortized mortgage is the least risky kind of mortgage obligation. If you can make the payment – a payment that will not change over time – you get to keep your home. A 30-year term is most common, but if you make bi-weekly payments (makes two extra per year), you can pay the loan off in 22 years. If you can afford a larger payment in the future, you can increase your payment and amortize over 15 years and pay off your mortgage quickly. The best insurance you can have to deal with unemployment or disability is a house that is paid off. As you can see, stabilizing or eliminating your mortgage payment reduces your risk of losing your house or facing bankruptcy. Unfortunately, payments on fixed-rate mortgages are higher than other forms of financing.

The interest-only, adjustable-rate mortgage (IO ARM) became popular early in this bubble when fixed-rate mortgage payments were too large for buyers to afford. In the bubble of the late 80’s, these mortgages did not become common, and the bubble did not inflate beyond people ability to make fixed-rate conventional mortgage payments. This is also why prices were slow to correct in the deflation of the early 90’s because most sellers didn’t need to sell, so they just waited out the market. It was a market correction characterized of large inventories, but this inventory was mostly not the “bad” inventory of must-sell homes. The few must-sell homes that came on the market in the early 90’s drove prices lower, but not catastrophically because the rally in prices did not get too far out of control; however, this bubble is different.

IO ARMs are risky because they increase the likelihood of losing your home. IO ARMs generally have a fixed payment for a short period followed by a rate and payment adjustment. This adjustment is almost always higher, and sometimes, it is much higher. At the time of reset, if you are unable to make the new payment (your salary does not increase), or if you are unable refinance the loan (home declines in value), you will lose your home. It’s that simple. These risks are real, as many homeowners are about to find out. People try to minimize this risk by extending the time to reset to 7 or even 10 years, but the risk is still present. If you had bought in 1990 with 100% financing on an interest-only loan and had to refinance in 1999, your house was probably worth less than you paid, and you would not be given the new loan. Even a 10 year term is not long enough if you buy at the wrong time. As the term of fixed payments gets shorter, the risk of losing your home becomes even greater.

The advantage of IO ARMs is their lower payments. Or put another way, the same payment can finance a larger loan. This is how IO ARMs were used to drive up prices once the limit of conventional loans was reached (somewhere in 2003 in OC). A bubble similar to the last bubble would have reached its zenith in 2003/2004 if IO ARMs had not entered the picture. In any bubble, the system is pushed to its breaking point, and it either implodes, or some new stimulus pushes it higher. Enter the negative amortization (Neg Am) mortgage (aka – option ARM).

The Neg Am / option ARM loan is the riskiest possible loan imaginable. It has all the risks of an IO ARM but with the added risk of an increasing loan balance. Using this loan, not only do you have the risk of not being able to make the payment at reset, but you are much more at risk of being denied for refinancing because your loan balance can easily exceed your house value. In either case, you lose the home. (According to Businessweek’s Map of Misery, 32% of new and refinanced mortgages in Orange County were of this type. See article Nightmare Mortgages)

The risk management measure not related to the mortgage terms is the downpayment. Most people don’t think of downpayments as a way of managing risk, but banks do. Downpayments reduce your risk in two ways: first, they lower your monthly payment, and second, they give you a cushion ensuring you can refinance (if necessary) should your house value decline. The problem with downpayments is obvious: few people save enough money to have one.

Eliminating downpayments through the use of 80/20 combo loans was another massive stimulus to the housing market. Lenders used to require downpayments because it required a borrower to demonstrate the ability to save. At one time, saving was considered a reliable indicator as to a borrower’s ability to make timely mortgage payments. Once downpayments became optional, a whole group of potential buyers who used to be excluded from the market suddenly had access to money to buy homes. Home ownership rates increased about 5% nationally due in part to the elimination of the downpayment barrier.

The combination of IO ARMs, Neg Am / option ARMs, and 80/20 combo loans took what would have been a bubble like the 90’s and turned it into an uberbubble (look at it as a bubble built on top of a bubble). In the early 90’s in California the median home price dropped from around $200K to $175K, about a 12.5% decline. The current bubble is about three times as large. Does that mean a 37.5% decline is coming? Only time will tell.

When I say I am financially conservative, I am saying I will only finance a home with a fixed-rate conventionally-amortized mortgage and a sizable downpayment. The reason for this is simple stress management: I don’t want to spend the next several years worried about my loan reset or house value or future salary raises. I will buy someday, not because I want to make a fortune in Southern California real estate, but because I want to have a stable housing payment, and a stress-free life.