Like millions of other Americans, my wife and I are upside down on our home mortgage – i.e., the amount we owe exceeds our home’s value. If I had it to do over again, rather than buy with $0 down, I would rent, save money, and buy only after it made more financial sense than renting. If only I could go back in time to alter our decision to buy!
Oh well, our plan moving forward is to pay off our mortgage early and stay put until prices trend upward.
As an aside, if you want more information on buying a home vs. renting you can check out Laura’s view of the buy vs. rent dilemma, as well as my opinion on the same thing.
Mistake #1 – Zero down mortgage
So many new homeowners made the mistake of entering into a zero down mortgage. If you cannot afford a down payment of at least 20%, lenders typically require either a 2nd mortgage or carrying private mortgage insurance (PMI).
One positive result of the housing crisis has been a huge scaling back of the zero and low down payment mortgages, which has been a large contributing factor of plummeting home sales. Nowadays people who don’t have any money cannot buy houses. Go figure, right?
2nd mortgages and Private Mortgage Insurance (PMI):
Private mortgage insurance (PMI) is insurance payable to a lender or trustee for a pool of securities that may be required when taking out a mortgage loan. It is insurance to offset losses in the case where a mortgagor is unable to repay the loan and the lender is not able to recover its costs after foreclosure and sale of the mortgaged property. Typical rates are $55/mo. per $100, 000 financed, or as high as $1, 500/yr. for a typical $200, 000 loan. (source)
A second mortgage (commonly used as an alternative to PMI) is a secured loan that is subordinate to another loan (your 1st mortgage) against the same property. The 2nd mortgage typically carries a significantly higher interest rate and is typically used as part or all of the 20% down payment. The higher rate is a reflection of increased risk to the lender, and results in much higher interest costs to the borrower over time.
We fell into this trap like so many others. We wanted to get into our new home now, and were ready to employ any creative financing necessary to make it happen… And so we entered into a 2nd mortgage for 25% of the purchase price (75/25 loan.)
To avoid a costly 2nd mortgages or PMI, save at least 20% of the purchase price of the home.
Mistake #2 – Buying high and selling low
Whether you’re trying to time the stock market or time real estate transactions, buying low and selling high should always be the goal. In a bad market the temptation to do the opposite can be powerful.
Take my housing situation, for example. I hate the fact that we have debt at all, and am very tempted to sell, despite the fact that we would have to take a loss! I’m tempted to sell our house for a loss and then rent for much less than our current mortgage payments and pay off our remaining debt while renting.
Though getting out from under the mortgages is tempting, I decided against it for mathematical reasons. If we were to sell now, we would not only lose money on the transaction, but we’d have to pay cash to our lender. If I could wind up even money, I would sell tomorrow. Instead, we are doing the next best thing… Making our 2nd mortgage the next victim of our debt snowball.
The faster we can reduce our amount owed, the sooner we can sell without any out-of-pocket costs. Our hope is that the housing market will bounce back in the mean time, affording us the option to sell for gain. 🙂
To avoid selling your home for less than you owe, increase mortgage principal payments and wait for the market to rebound.
It is worth mentioning that we cannot control market conditions, so we should spend our energy focusing on the factors that we can control:
- Once you have high interest consumer debts under control, focus your debt snowball on reducing your mortgage – and look into refinancing your mortgage to see if rates are attractive as you may be able lock in a lower rate. If you have a 2nd mortgage, pay it off ASAP. Those of you with PMI should also focus on reducing your mortgage principal to speed your ability to drop the PMI once your principal is reduced below 80% of the home value.
- Make property upgrades that raise the value more than the amount they cost to implement. DIY projects can cost very little, yet yield superb ROI.
In closing…
Most who fall victim to either of these housing and mortgage blunders end up paying dearly. I hope this article will help future homebuyers avoid the same mistakes. For our next home purchase, my wife and I intend to save 100% of our payment before buying… But that is a post for another day! 🙂
This may sound unfair of me, but I’d prefer it if people couldn’t buy a house unless putting SOMEthing down. At least 5%. You have to feel like you’ve invested something. I think so, anyway. If you can’t afford a house without 100% financing, perhaps you should continue renting for another year or two while saving up a bit. There’s no shame in renting.
Hi,
I am in a very similar situation, I got caught up in the real estate hype. I bought my townhouse back in June of 2005. I too, put 0% down and did a 80/20 loan. My first mortgage is 6.125% while my second is 8.375%. I am a little bit upside down on my townhouse. My purchase price was 183k and the current market value is 175k. Right now I am renting out the spare rooms in my townhouse to aggressively pay down the 8.375% mortgage. I plan to be finished paying the second mortgage at the end of 2012. So far with the two roommate renting from me it is costing me the same as rent if I were renting. I blog about my renting out my spare rooms on my blog http://www.rentingoutrooms.com and offer tips and stories about renting out my spare room.
Unfortunately, some people made those two mistakes and more as indicated by the number of home foreclosures out there. Some people bought alot more house than they could afford and also used exotic mortgages to purchase them. I don’t think those type loans are available anymore (neg amortization loans).
@John: You are correct, and that is our plan.
From the post:
I think the difference in being upside down on property versus being upside down on a car is that a car is a commonly depreciable asset. When you buy a new car you expect it to lose 10-20% of it’s value in the first year if not more. You do not expect a house’s value to decline severely like many have seen in the last few years.
@Matt: From the sound of things you are very slightly underwater on your mortgage. I know it eats at you but this does not feel like the right time to bail on a house and become a renter. You will have to shell out cash to pay off the mortgage and brokerage fees on top of paying a deposit on a rental, so you have a large outlay of cash initially. How much can you save monthly by renting versus paying the mortgage and how long would it take to rebuild the savings lost to the home sale? I know your goals are different now but the situation should improve. If the value continues to decline at the same rate that you pay off the mortgage, you may still be money ahead to stick it out. You have 0 equity now, but you will still have 0 equity if you pay out and sell the house.
@RS: Yes, my wife and I would like to sell. Upside down on real estate is often dealing w/much higher $ amounts than autos or other assets, I’m assuming that is why people make a bigger deal of it.
I bought in Aug. 2008. I did an 80/10/10.
Rounding the numbers except the interest rates..
80% Primary Loan (300k) @ 6.5% for 30yrs fixed
10% Secondary (40k) @ 8.25% for 30 yrs fixed
10% Down
When I got all my GFEs, this turned out to be marginally cheaper (like $30) than a 90% financed loan + PMI. PMI was on the order of $170/month, which is still currently deductible on your taxes. However, it looks like being able to deduct PMI on taxes was not the norm, so this tax advantage could change any year.
It would have taken me 8 yrs to pay off the PMI.
I went with the 80/10/10, even though based on my payment calculations of prepaying, I would pay it off in the same amount of time (8 yrs). It just gave me some flexibility, in terms of the banking relationship I’m establishing.
While I could have paid more towards the 90% loan as well and got rid of the PMI earlier, I would have had no chance to refinance that loan in the short term. I actually just barely managed to refi recently.
I’m might of missed it from earlier posts, are/were you looking to sell right now? I’ve never understood why people are worried about being “upside down” unless you are actively trying to move or planning on moving soon. Owing more than something is worth is common when people buy cars, yet people don’t seem to be as distraught over that.
When I bought my place, I remember the seller’s agent kept telling me that the seller was “upside down”. So I went and looked up the land records, and technically he wasn’t. True, he was selling it for less than he bought it for, but he OWED less than I purchased it for (even after paying the agents etc).
I bought in October of last year and I am currently paying PMI. I would not have considered buying except for the first-time homebuyer credit. As soon as I get my tax return with the credit I’ll be reducing my loan principal and eliminating PMI. Without the tax credit, I probably would have been shopping to buy during summer 2010. I couldn’t pass up the opportunity to claim the credit and take advantage of the silly low interest rates last fall.
As it turns out I would have been better off to wait until this spring, but the difference is not major. A year from now I’ll have 25% equity in my house, a minor student loan payment, and no other debts. I’ll be capable of socking away about $1000 in savings along with 10% of my income into retirement every month.
Good point on buying low. Often we have no control over when we sell. Many homes are sold because of transfers, death and divorce.
PMI is something I would avoid at almost any cost. You are paying insurance where someone else is the beneficiary.
Howdy Matt – Yep, your response about “financial priorities” changing makes excellent sense (and cents). Good luck with it, you never know there is always someone else that may fall in love with it and pay $10 more a square foot than the comps!
@Ben: Do you have at least 20% saved for a down payment? If not, then my staunch and experienced advice begs you to parlay your desire for a home until you can save at least that much. Trust me on this one… just keep renting until you have SAVED SOME MONEY. I know how it is when you really want to buy… but please make sure you do not make the same mistakes so many (like me) already did.
I’m thinking about going with a loan through Navy Federal Credit Union. They’re offering a no-down-payment loan with no PMI right now. Presumably they will defray some of the risk with a loan of this type by inserting a lot of extra fees but, considering it seems your primary objection to a no-down-payment loan is having to get a FEL or HELOC for the remaining 20% or pay PMI, do you think this would work out ok?
@JT: Yeah, our DTI is actually really good compared to most other people… I am simply much more anti-debt than most, so any amount makes me uncomfortable, especially if any portion of it is unsecured.
@Bodark: We want to sell because our financial priorities have done a 180 since we bought… it is all based on my lack of thorough decision making previous to buying. Yes… 6 & 9 are reasonable rates – plus we are currently doubling the principal on our 2nd and starting in April will make it the next target of our debt snowball ($2,000+ payments/month.)
Post makes sense, but my underlying question is: Why do you want to sell(besides the finance part)? Did something change since the closing date (e.g. neighborhood decline, commute, etc..).
If you still like the home, I would consider the Interest Rates on the mortgages moot (although 5 and 8 are reasonable)as you could pay them off earlier, and make the ‘effective rate’ much less (say 5 and 3).
Although, at the potential to offend some readers. PMI is truly a scam, meant to drive profits at the mortgage/insurance underwriter level. Get a broker a few drinks, then start asking some questions.
Thank you Matt.
The good news is at least your not in a bubble state! While you may be underwater, the actual dollar amount is nothing like I was expecting; I’m used to hearing people underwater by $50,000+ on their mortgage, which is a whole different ballpark in my opinion.
@John: Ouch… the last decade in the housing market has been a lesson to most all of us.
My girlfriend is in a similar situation. She bought about 4 years ago on a 0% down mortgage. Her loan has “Lender-paid PMI” Which to me just means they jacked up the interest rate for the life of the loan instead of requiring PMI payments until 80% L/V was reached.
Anyway she did several remodeling projects, but since she had no equity in the house from the beginning, she put it all on credit cards. Now her house is worth slightly less than the mortgage value despite the improvements and she has another 20% of the home’s value locked up in credit card debt from the renovations. Not only would she have to take a foreclosure/short-sale to get out from under the house, but would have to take bankruptcy to get out from under the CCs, either that or spend the next 7 years paying them down.
@Dan & JT: My starting debt amounts.
1st mort = 5.825%
2nd mort = 8.8%
mort = 75/25, $0 down, no PMI
@Funny A $: Good point, you can never cover every sitch w/a broard brushstroke. I would say that people who bought between 2002 & 2007 may never see purchase values return, but over the long term I’m confident values will stay 1% above the inflation rate. Cutting losses may indeed be wise for some, but that is a tough call to nail down! Godspeed.
I sure hope you’re right that the market will rebound someday. Personally, I’m losing hope that real estate values will ever recover enough to put me and my son above water on the house we’re copurchasing.
When we bought, we and our fairly seasoned real estate agent believed the market was near bottom. We figured the value would drop about $4,000, level out, and then after several years return to normal. We thought the price we were paying was pretty close to normal — neighbors expressed their anger that the seller had sold to us for what they thought was a ridiculously low amount. How wrong can you get?!?!?!?
The house is now worth about $85,000 less than we paid for it, with no sign whatsoever that values will ever increase. With prices in the sub-basement, houses around it are being turned into rentals or sold to people whose cultural values do not include maintaining the property they live in. Thus it’s highly unlikely that the neighborhood will recover from the thumping it’s had in the Not-a-Depression.
Under these circumstances, it’s not unreasonable to think seriously about cutting your losses and walking. To pay off a mortgage that’s way, way more than the house will be worth in the foreseeable future is to throw good money after bad. Sticking tight may not be the right thing for everyone.
Matt,
It’s not obvious to me where the data we would like to see is buried.
(Friendly hint: Don’t make me dig for those numbers. Could you rewrite the post to include them?)
@Dan & JT: Already done gents, to see my numbers and progress follow these DFA tags: mdrss and hmodc.
@Sam: Precisely why I say those who cannot afford should not buy.
#2 is definitely a tough one Matt, and I feel your pain given I bought a vacation property higher than where it is now. That said, i plan to hold it forever, as it is a lifestyle choice. It’s not a flip.
Regarding #1… no money down is not bad. It’s only bad if you do no money down b/c you have NO MONEY! If you have the 20% down sitting in your bank account earning a greater return than the cost of your mortgage, invest it elsewhere.
Best, Sam
I agree with Dan and would like to add a little more as well.
I’m a regular reader of many personal finance and economic blogs. When I read personal finance articles I tend to skip over the ones that are too general or say what has already been said a thousand times.
Articles that I read and, most of the time, comment on, are the ones that involve difficult and specific situations where the answers are never clear. They are always interesting to me and, I’m sure, to many others as well. Giving hard numbers to real life situations is one of the things that many authors should take note of and strive to accomplish more often.
If you’re a blogger interested in getting more attention on your site then you need to be brave enough to share some personal details with the world. You don’t have to give out your Social Security number, and I understand everyone has the right to privacy, but sharing some details like what you paid on your house can be valuable to the discussion at hand and the community as a whole.
So, I say to Mr. Jabs and all other bloggers, if you really want to help others understand personal finance please take the time to share some of your life’s difficult decisions. Give us some plausible real-life situations to encourage a discussion, and subsequently, an understanding of them.
Thank you.
Matt,
I want to see some numbers, too (you told me a month or two ago that you’d work on it!). They put context into things. Right now, all your post really says is “if you buy with less than a 20% down payment, you either have to pay PMI or take out a second mortgage.” That doesn’t tell most of us anything we don’t already know… and for those of us who are still renters, things like this are terribly important to consider before making the leap.
1. What was your purchase price?
2. What was the interest rate?
3. How much is your payment?
4. What is the rate on your second mortgage?
5. How much is your payment on that?
6. What would PMI have cost you?
I learned a very hard lesson when I was looking for funding for my condo. We utilized a few mortgage brokers (because who didn’t have multiple friends in “the business” 2005 to 2007?) and so each pulled my credit report.
When push came to shove we got a worse deal because I did that. Rough!
Fair enough. You have to do what you’re comfortable with; there’s no point in defaulting if it makes you feel worse than being underwater.
@Lakita: Any move you can make that reduces the amount of interest you pay, or the amount of debt you take on is wise!
@JT: Great questions raised. You are correct in stating that mathematics are on my side if I bail, but there are other factors in play for me… I gave my word to pay a certain amount and so that is what I will do. People may disagree, that is fine… to each his own. The banks may have done wrong by bloating value and allowing $0 loans, but ultimately I take personal responsibility for my own mistakes and my own decisions. All that said, I do not project my position onto others. Everyone needs to do what is right according to their own conscience. 🙂
Can you give us some context into your situation? How much are you underwater? What what the original loan you took out and what is the current market value on your home?
I’d love to see some numbers from a person who is, unfortunately, living through a situation like that. I would also really like to hear about your thought process in deciding to stick with making the payments. You’ve said it was for mathematical reasons but have you considered that the average borrower gets 18 months mortgage-free living from the time they stop paying their mortgage to the time they are foreclosed upon? This could easily affect your numbers and could allow you to save tens of thousands of dollars.
Matt,
There is another option for those that do not have 20% down nor want PMI….but it is not available to everyone which is probably why it isn’t talked about much and that is the VA loan (veteran’s administration). It is very much like an FHA but it doesn’t have the PMI.
I’m looking at buying my first home soon, but since you are paying more in interest for the first 1/2 of your loan term….my strategy is to buy less house and at least double my payments.