Keeping your head up in a depressed housing market
By Michael D. Larson • Bankrate.com

Kathy Perron wants a yard. Somewhere she can plant flowers, start a garden -- do all the things she can't in the Elkhart, Ind., condominium she shares with her husband and a daughter.

But the 43-year-old credit counselor knows any potential transaction has to make financial sense. Because home prices have fallen more than 6 percent in her area, she says she may have to wait before trading in her condo for a house.

Weakening housing prices aren't just a problem for Elkhart, a northern Indiana city near South Bend. Recent surveys show prices falling or stagnating in markets around the country, from Charleston, W.V., to Boise City, Idaho. While weak markets are still in the minority -- and prices continue to appreciate at a decent pace nationally -- existing mortgage holders, potential home equity borrowers and new home buyers should take note of the trend. They may have to adjust their borrowing and shopping strategies now to avoid trouble down the road.

"I can hold off for the garden until it's fiscally smart, until it makes sense for us financially," says Perron. "The last thing I'd like to do is commit to buy a house for $120,000 and then three years down the road, if we decide to relocate, have somebody tell me, 'Well, your house is not worth what you paid for it.' You've got a problem there and I want to make sure it's stable.

"If I really want to plant something," she jokes, "I can buy a flowerpot to put on my desk."

While the housing markets have held up fairly well in the face of the economic slowdown thanks to relatively low unemployment and falling mortgage rates, job cuts in many industries are mounting. More than 500,000 layoffs have been announced in the U.S. since Dec. 1, concentrated in the telecommunication, auto and retail sectors. Along with the yearlong slump in the stock market, the layoffs have put pressure on real estate sales in some areas.

"Over the last 10 or 15 years, home prices have really year after year increased or escalated. But in the last three or four years we have seen that slow, and in some particular markets we have actually seen some price decreases," says Jim Seitz, senior vice president for consumer banking at South Bend-based 1st Source Corp.

"As we're counseling individuals and sitting down with our borrowers, when they come in to fill out financial statements with us and expect their homes have substantially increased in value, we let them know from the data we're seeing and the appraisals coming in, we're not seeing that."

In 1st Source's home base, for example, the median price of an existing home fell 6.2 percent between the fourth quarter of 1999 and the fourth quarter of 2000, according to the National Association of Realtors. The median price is the midpoint for prices; half of the existing homes in the northern Indiana town and surrounding area sold for less than $79,800 in the most recent period, while half sold for more.

Declining markets
The local decline was the largest found among the 121 metropolitan markets covered in the NAR survey, which turned up 10 declining-price markets overall and 13 more where prices rose by 2 percent or less. Areas showing declines included Charleston, W.V., (5.3 percent) and Daytona Beach, Fla., (3.5 percent).

Another 75-market survey by the Meyers Group, an Irvine, Calif.-based real estate research firm, showed the largest price declines between 1999 and 2000 in Raleigh, N.C., (4 percent), Birmingham, Ala., (2.1 percent) and Sarasota, Fla., (1.9 percent). A total of 15 markets either had falling median prices or prices rising by less than 2 percent.

"What you're selling your home for depends on what someone is willing to buy," says Martin Rhodes, vice president at Solution One Mortgage of Charleston. "Our industry base is like a roller coaster ride. We've been losing some jobs in our manufacturing base even though we're picking up a couple elsewhere. When this sort of thing gets publicized day after day after day, it has a looming effect where people are scared to go out and spend a dollar.

"People say, 'Hey, maybe we should wait to go out and buy until we see how things play out.'"

To cope with these conditions, borrowers and buyers should adjust their financial behavior. Consumers who are shopping for homes in weak markets, for example, have to be sure they're going to stay put for a while. Potential buyers with shaky jobs or first-time shoppers who plan on starting families and moving to bigger homes a year or two down the road may want to just rent.

Why? It doesn't take long to recoup a couple thousand dollars in mortgage closing costs when values are rising. But when they're falling or remaining stable, homeowners who can't stick around and wait out the sluggish period end up losing money. The difference between the purchase price they pay and the price at which they sell isn't enough to cover the upfront closing costs, the back-end real estate agent commissions and any upgrades and renovations.

Perron, for one, may stay put until the market improves. The counselor with Consumer Credit Counseling Service of Northern Indiana Inc. says she and her husband Jim, 45, bought their condo three years ago for $75,000. After putting $15,000 toward upgrading the unit inside and out, she's afraid their investment won't pay off at closing time.

Her concern may be warranted. In Elkhart County, where the Perrons' condo is located, 1st Source Corp.'s average mortgage size fell to $101,250 this March, down 7.1 percent from $109,000 a year ago. That suggests sellers are struggling to get the prices they want.

"I would be afraid of not selling our home and getting my investment back," Perron says. "We have remodeled the kitchen, renovated the bathroom.

"We've invested a lot of money in that, and if I'm not going to get my investment back, I'm not willing to sell it."

Because of potential problems with home prices, this isn't a good time for borrowers to stretch their budgets at purchase time, either. Doing so may cost more now than in the past because of the way private mortgage insurance (PMI) works.

Over the past couple years, buyers were able to put little money down and buy expensive homes. That results in loans that have a high loan-to-value (LTV) ratio -- and the expensive monthly PMI payments that come with those loans. Where homes appreciate quickly, buyers could get away with the tactic because PMI payments would quickly vanish. That's because when properties appreciate quickly; 95 percent LTV loans turn rapidly into 80 percent LTV loans, and that's the threshold at which most lenders allow borrowers to waive PMI. But with stable prices and the long amortization schedules of 30-year loans working against them, borrowers could get stuck paying an extra $150 or $200 a month in PMI payments for many more years.

Refinancers and consolidators beware
Current homeowners who are thinking about refinancing or taking out home equity loans to consolidate debt while rates are low should be careful, too. For one thing, some customers who have done so in the past have gone out again and racked up new credit card debt. When prices are rising, enough equity becomes available that those homeowners can refinance again and try to do things right the second time around. But when prices are falling, the equity isn't there and the debts can overwhelm them.

"We tell them the truth," says Rhodes, the Charleston mortgage broker. "It's like, 'At this particular moment in time, the loan that you're desiring, I just can't do it. You told me the home was worth $100,000 and it appraised at 90 and you owe 85. This loan doesn't make sense for you.'

"Unfortunately, that does happen."

Customers who borrow at high loan-to-value ratios to consolidate debt or make home improvements could end up owing more than their properties are worth, too. That's because they don't have equity cushions large enough to absorb price declines. A borrower in that position faces an array of bad options if a job loss or something else forces a home sale:

• Pay the lender the difference between the mortgage balance and the sale price out of savings;
• Try to negotiate a "short sale" in which the lender accepts less money at closing than it's owed; or
• Walk away, hand the keys to the lender and end up with a foreclosure on the credit report.

Homeowners who insist on borrowing anyway may want to consider making extra mortgage payments so they don't get caught "upside down" like that. The same holds true for people who already have a lot of mortgage debt from past loans, but don't think they'll have to move anytime soon.

"We would always encourage that, making sure that when they do send extra money in for their mortgage that they specify it's marked for principal reduction," says George Rienberg, president at CCCS of Kanawha Valley in Charleston.

But if the economy gets worse and prices collapse, consumers may want to consider just walking away from their loans, even though doing so can wreck their credit. In theory, a lender can come after the personal assets of a borrower who it forecloses on if the post-foreclosure sale doesn't net enough to pay off the customer's loan. But the judicial burdens of doing so and the relatively slim chances of recovery deter many lenders from bothering.

John Burns, a vice president at Meyers Group, recalls some research he did a while back on the Antelope Valley region of Los Angeles County in California. When the market there was hot, builders were selling 5,000 new homes a year and homeowners were building equity at a healthy clip. But when sales cooled in the early 1990s, prices collapsed. Homeowners were so deep in the hole that some handed their keys to their lenders and rented homes across the street at monthly rents that were substantially lower than their mortgage payments had been.

"I don't want to sound like an idiot saying it's OK destroying your credit for seven years, but a lot of people thought it was the right financial decision for them," Burns says. "If you only put $5,000 down and your home goes down $20,000 in value and you decide to give the home back to your lender, you've really only lost $5,000."

Burns doesn't expect things will get that bad anytime soon. After all, median prices rose 4.3 percent nationally between 1999 and 2000, and most economists think the United States will avoid recession this year. But counselors recommend homeowners and potential borrowers in today's market follow an old adage: "Hope for the best; prepare for the worst."

"Obviously as much as we want to encourage homeownership, I think it's important to also encourage saving," says Perron. "I would not advise someone to jump into anything now without planning."