Ask anyone in the mortgage or real estate industry how to avoid buying a house that will end up underwater, and the immediate response is a cackle and quick-witted retort. “You would need a crystal ball for that” is the most common response.
The uncomfortable fallback to humor is warranted, considering the fact that 11.2 million homes in the United States are underwater, according to a CoreLogic study done in May. A majority of those homeowners probably never anticipated that the American dream would turn into the American succubus.
Real estate was once a sure bet. Now our government has to entice homebuyers with tax credits, and with the tax credit gone, homebuyer confidence has dwindled. Pending home sales in September dropped 24.9% from the September 2009 numbers when the tax credit was available, according to a recent report from Realtor.org.
But the reasons to buy have not entirely disappeared. There is the low-hanging fruit that anyone in real estate can dangle in front of prospective buyers—interest rates remain at all-time lows and prices have fallen as well.
On the flipside, there is the argument that it’s better to rent than buy. Why build a landlord’s equity instead of building your own?
It’s tough to build equity when you buy a house for $200,000, put down $20,000 and a couple years later the home is worth $100,000. That’s not a far-fetched example with what has happened the last few years. Add the fact that you’re locked into a higher rate and cannot refinance, because most lenders are not going to refinance a home that is underwater, and that’s reason enough to be wary of buying.
So if you’re in the market to buy, should you just run out and rent instead? Not necessarily. Sure, things have changed, but in the long run, the changes should just make Americans more careful.
“It needs to be sort of that old school, I want to be here approach. I want to put roots down,” said Kathy Partak, who works for the nonprofit financial planning company Aim Financial Solutions in Northern California. “It’s not so much an investment as it is my home.”
The best investment is obviously a home where you plan to stay for the foreseeable future. There are the essentials that every family considers: good schools, low crime rates, location and the local economy. All four of these things affect home values.
Some neighborhoods that would have been considered good neighborhoods 10 years ago—and even may still have that appearance—have seen their value drop because of delinquent borrowers.
Prospective buyers should research the number of foreclosures in an area. Foreclosures drop the value of other homes because a foreclosed property often sells for less than its worth.
More and more foreclosures are happening because of borrowers walking away from a home. The reason many do so is because the home is underwater. This is not just happening in high-poverty areas. Often, borrowers are strategically defaulting in what many would consider nice neighborhoods, and this also drops the value of nearby homes.
“Even if they only had 500 properties go into REO this month, and they’ve got 9,500 new listings filed, then down the road, those foreclosures when they resell at 27% under market value are driving house prices down,” said Shari Olefson, a Florida lawyer and author of “Foreclosure Nation: Mortgaging the American Dream.” “You want to look and see how much shadow inventory is in your area, how many properties are listed, how many loans are in default or foreclosure and that’ll give you an idea of what the supply side of the equation looks like.
“Then you can look at how many homes are being purchased for an idea of demand, and then you can get an idea of how much excess surplus there’s going to be. If you’ve got a three-year surplus in your area, chances are prices are going to go down.”
Another statistic to study is unemployment. If there are not a lot of jobs available in the area, home values will fall.
If the foreclosure rate and unemployment numbers are not up to par, but showing improvement, it could be worth the gamble to buy a foreclosed property. The one caveat here is that the current foreclosure investigation by all 50 state attorneys general has added even more risk to buying a foreclosed property. However, a foreclosed home will sell for less and in the long run, and that investment could pay off.
Vic Gonzalez, who buys foreclosed homes in San Antonio, said he typically offers 60% to 70% of the asking price.
Gonzalez researches the properties he’s interested in as soon as they are listed. Foreclosure fillings are filed usually 21 to 30 days ahead of time, and you can also search for foreclosures on the Web through Department of Housing and Urban Development websites. In Texas and New Mexico, foreclosures are listed at southwestalliance.com
Gonzalez suggests that when you make an offer, bring a prequal letter stating that you’re prequalified with a lender and ready to purchase.
“Sometimes they’ll accept,” he said.
Andy Gagliano, a mortgage loan officer in Birmingham, Ala., gives his clients one big piece of advice when they’re considering buying a home: Make a budget.
“I know it sounds so simple,” Gagliano said, “but it’s amazing the number of people who don’t do that these days.”
Gagliano suggests you take the amount of money that you would put toward a monthly mortgage payment and put that amount in a savings account every month. If you’re not already paying utilities, add what utilities would cost to the monthly amount. If you can go several months without touching that money, then you should be prepared to pay your mortgage.
“Don’t force something to happen,” Gagliano said. “Mortgage guidelines are in place for two reasons. That’s to protect the lender and to protect the borrower. Neither party wins in the case of a foreclosure or a default on a mortgage. The lenders want the borrowers to stay current, and the borrowers want to stay in the house and that’s the way it needs to go.”
Gagliano tells his clients that their monthly mortgage payment should not be more than 33% of their gross monthly income and you should not exceed 41% for all debts.
Sandy Frame, president at the Real Estate Education Center in New York, suggests you multiply your gross annual income by three and that’s how much house you can afford. So if you make $100,000, you can afford a $300,000 house.
Depending on whom you ask, most suggest you stay in the 31% to 33% range.
“Those ratios are definitely set for a reason—the front and back-end ratios—and tricking them is like finding out your doctor cheated on his medical school exam,” Olefson said. “He’s the last one you want doing your appendectomy. You may be thinking you’re getting away with something in the short term, but in the long run, you’re not. The only one you’re screwing is yourself.”
Expectations of great appreciation, like many had during the housing boom, was not always the norm. In the 1960s, Olefson points out, housing appreciated about 1% annually and then went up to about 3%.
“Now it’s going to be more in line with that,” Olefson said. “I don’t think people should be buying a home as some end-all. It’s a great way to build a nest egg. The truth is if someone sat down and did the math, you’re better off taking that same $200,000 over 20 years and investing it. There are other investments that you can invest in that are better. The problem is there are risks associated with everything.”
In the end, there are enough reasons to justify buying a home, especially with the interest rates and current home prices, which may still drop.
Olefson points to Warren Buffet, who is historically one of the best investors. Buffet has always said that you don’t wait for prices to bottom out. You wait until the price is a good price, and that’s what housing is right now.
C.J. Moore is the editor for LenderStreet.com, an online mortgage lender matching service based in Kansas City, Kan.
