Tuesday, July 5, 2022
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The Return of Underwater Mortgages


In a previous life, my mom used to be a real estate agent, and she often shakes her head at the crazy behaviour of “kids these days” buying houses over Zoom, getting into massive bidding wars, and the signing condition free offers. Back in HER day, people would make their offers conditional on financing, or selling their existing home. They would insist on home inspections! And they definitely would want to see the damned thing in person before plunking down their entire life savings!

However, there is something from “back in the day” that might be making an unwelcome return: Underwater mortgages.

An underwater mortgage happens, basically, when the amount you owe on your mortgage is greater than the value of your home. It means that even if you sell your home, you still owe money to the bank. It also means, by extension, that you need to have enough money to cover the the remaining balance of your mortgage before the bank will permit you to sell. In other words, if you don’t have enough, you literally can’t afford to sell and are effectively trapped in your home. You may also be forced to declare bankruptcy.

This is, to put it mildly, a pretty stressful situation to be in.

In fact, one of the most unpleasant experiences my mom remembers (and one of the reasons she got out of the business) was being the agent in charge of selling properties that had underwater mortgages on them.

In this situation, the home owners are being forced to sell for some reason. Maybe they lost their job, maybe they’re getting a divorce, whatever the reason is, they can’t just sit in the house and wait for its value to recover. So that means they’re losing money on this sale and they know it. The only question is, how much?

So this means that the seller needs to sell for as close to what they paid as possible. Any amount lower than that means they have to come up with a check for the difference to pay off the bank. They also need to sell fast. Because underwater mortgages generally happen in a declining real estate market, the longer they wait the worse it gets.

Put that all together and you get panic attack city. And guess who has to bear the brunt of all that rage when feelings collide with reality? You guessed it, the real estate agent. Despite the fact that it’s not the agent’s fault that these entitled whiny brats only had themselves to blame for overextending themselves in the first place thinking houses can only go up in value and never down.

Well, those days appear to be coming back. Arguably, they might already be here.

How Did We Get Here

Lots of things affect housing prices, from government policies that encourage or discourage home ownership, to the job market, to immigration patterns. Most of these things we can’t predict, which is why people who try to predict the direction of the housing market have such a bad track record.

However, one thing that always affects housing prices is interest rates.

Interest rates, as set by central banks like the US Federal Reserve, the Bank of Canada, or the European Central Bank, affect borrowing costs for things like credit card debt, business loans, and crucially, mortgages. The higher the benchmark rate is, the higher mortgage rates are and vice versa.

The mortgage rate also affects how much a bank is willing to lend to a potential buyer. Banks calculate this using something called the Total Debt Service Ratio, or TDS. Without getting into the details, the TDS is basically a measure of how much of your monthly salary would be taken up by the loan payment. Different countries use different TDS ratios, but generally 40-45% is the highest banks are willing to go in approving new mortgage debt.

So that means that if interest rates go up, the monthly payments would go up. And if your salary doesn’t change, the amount the bank would be willing to lend has to go down in order to maintain the same TDS ratio.

The last time this happened was in the late 80’s. Following rampant inflation, then US federal reserve chairman Paul Volcker raised interest rates in the US to nose-bleed levels of 15%. In Canada, ours spiked as well to 13%. The effect on the housing market was dramatic, with home prices plummeting 30%-40% here in Canada. That was the environment that my mom found herself in dealing with angry underwater homeowners.

So today, we’re back to seeing high inflation, caused by supply chain issues, rising energy costs, and a very unnecessary and destructive war in Ukraine. How high will interest rates go? Beats me, but according to some economists, it could get pretty bad.

For every percentage point of inflation, you raise interest rates by a percentage point or more. So…I would have to increase interest rates to more than 8%, said Markus Brunnermeier, a professor of economics at Princeton.

Just how high will interest rates go?, Marketplace.org

If you’re thinking “30% to 40% sounds scary, but 10% to 20% doesn’t so bad,” think about how over-leveraged people when they buy real estate. People don’t pay 20% down payments anymore (another relic of the “good old days,” according to my mom). They put down the bare minimum of 5%, and often have to raid their retirement savings to get even that. That means that for anyone who bought in the past year, it would only take a 5% reduction in housing prices to be underwater on their mortgage.

There Is No Such Thing as Good Debt

This is why I hate financial advisors who tell people that credit card debt is “bad debt” and mortgages are “good debt.” There is no such thing as good debt.

Debt of any kind puts you at the mercy of the giant, intricately interconnected global financial system in ways you can’t predict or control. Could anyone have predicted that Vladamir Putin would invade Ukraine, causing NATO to unite in sanctioning Russia’s economy, causing oil prices to skyrocket, causing inflation to shoot up, forcing central banks to spike interest rates, and causing housing prices to go down? No. Nobody saw that coming. Not even Putin, who started this whole mess to begin with, could have predicted that.

That’s also why during the pandemic when people were using record low interest rates to gobble up overpriced houses I was jumping up and down trying to tell people to cut that shit out. You’re supposed to use low interest rates to refinance your existing debt, not use it as an excuse to get into more of it.

But I guess I’m not that influential, because people didn’t listen. Nobody (except my mom, I guess) remembers a time when interest rates shoot up and housing plummets. The 1980’s was too long ago.

So here we are. The home boners have chained themselves to their real estate, once again, thinking the good times will last forever. Only this time, water is starting to seep into the basement, and it just keeps going up…and up…and up.

How To Defend Against an Underwater Mortgage

Ok so if you find yourself in this situation, what can you do about it?

It might be tempting to think: Nothing.

An underwater mortgage doesn’t blow up your finances if you don’t sell. You could theoretically just keep paying the mortgage, ignore your falling home prices, and just wait for your home’s value to pick back up again, however long that might take. It’s an attractive option. I mean, I love doing nothing. It’s the easiest thing in the world to do!

The only problem with that is, sometimes life circumstances force you to sell, in ways none of us have control over. Being laid off can happen to anyone. Same with a divorce. Or an unexpected illness.

If one of these happen, and you happen to be caught in an underwater mortgage situation, you are in for a world of hurt. You may even have to declare bankruptcy if your personal assets can’t cover the difference in your final sale price and the remaining mortgage balance.

So the best way to defend from this situation can be summed up in a single word: Deleverage.

Do whatever it takes to pay that shit off. Take on a second job, get rid of the car, take a hatchet to your expenses. Whatever you can possibly do, do it. And take that cash and throw it at the mortgage.

Don’t get me wrong, I’m not saying you have to pay off the entire mortgage. You just need to pay off enough of the mortgage so you’re no longer underwater. Once your remaining balance is equal to the value of your house, you can breath easier again and resume your normal spending. But as long as you’re in a negative equity situation, you should be in “Red Alert” panic mode and trying to throw as much money at that debt until the water level is below your head again.

Conclusion

Having debt is a dangerous game. There are just so many things that can go wrong and trap you in a situation where there’s no easy way out. That’s why I don’t use debt of any kind in my portfolio, because if something like this happens I could be forced to sell at a loss and possibly blow up my retirement.

And yet so many people think it’s perfectly normal to hold over a million dollars in mortgage debt because they’ve been taught mortgages are “good debt.” It’s complete horse shit.

Mortgages can turn against you. We haven’t seen a situation like that in the past 40 years, so people think it can’t happen, but it’s happening now. It’ll be interesting to see how home owners react to this new era of rising interest rates and underwater mortgages.

If it’s anything like what my mom remembers from the last time it happened, it ain’t going to be pretty.


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