Homeowners made a lot of errors in the years preceding the financial crisis. Most of those myriad mistakes can be boiled down to one fundamental miscalculation: People borrowed more than they could afford to repay.
In the most frenzied months of the housing boom, home prices in some markets zoomed up at a rate of more than 30 percent a year. At the time, many homebuyers found themselves gripped by something akin to gold fever. Buyers feared being permanently priced out of homeownership if they waited a few more months.
In hindsight, double-digit annual price increases were unsustainable.
“Consumers were naïve about economic cycles, getting caught up in the here-and-now euphoria of exploding property values,” says Jeff Lazerson, president of Mortgage Grader, a Laguna Niguel, Calif.-based mortgage technology and management company.
Too many borrowers got interest-only loans or pay-option adjustable-rate mortgages just so they could squeeze into a house with a barely affordable monthly payment. They ignored the possibility their monthly payments eventually could skyrocket. A lot of people simply didn’t understand their mortgages.
Homeowners compounded those errors with the worst blunder of all: borrowing the entire inflated value of the house or close to it. Buyers got “piggyback” loans in which they borrowed 80 percent of the purchase price in a primary mortgage, and 20 percent of the purchase price in home equity loans. Then house values fell, and these homeowners ended up owing more than their homes were worth.
A lot of those people have lost their homes in foreclosure, or eventually will.
Smart strategies going forward
It’s easy to tell people to never again borrow more than they can afford, or to avoid any mortgage they don’t fully understand. But another housing boom will come someday, and people will be tempted to make the same mistakes.
To protect yourself against such errors, realize the unexpected can happen, such as a decline in house prices. A homeowner who understands that house values can fall will be less likely to borrow 100 percent of the home’s value.
Many of today’s foreclosures could have been avoided had the homeowners made substantial down payments. Equity in a home acts as a cushion against falling house prices, allowing you to sell if you suddenly can’t afford the mortgage anymore.
By contrast, if you owe more than the house is worth, you can’t sell without the lender’s permission.
It’s also crucial to understand your mortgage. On loans in which the monthly payment can vary, consumers must know how high the monthly payments can go. Then, they have to judge whether such loans are affordable.
“It’s healthy to think positively. It’s foolish to become overly optimistic about real estate riches,” Lazerson says. “Always consider plan b, like, ‘What if rates move up? What if I don’t get the raise at work that I am hoping for?'”
Whenever the monthly mortgage payment greatly exceeds the monthly rental of a comparable house, it’s a sign that house prices are unsustainably high. When it’s a lot cheaper to rent, it makes sense to rent instead of buying.
Dean Baker, co-director of the Center for Economic and Policy Research, is an economist who sold his condo in Washington, D.C., before the bubble popped. His rule of thumb is that a sane housing market has homes with annual rents about one-fourteenth of the home’s value.
So, if one house is worth $140,000, an identical house next door should have an annual rent of about $10,000 a year, or $833 a month. That ratio can vary a bit, depending on taxes and utilities.
Finally, if you are tempted to buy a house because you fear soaring prices will leave you unable to afford it in a few months, take that as a sign you’re caught in a speculative frenzy.
Prices tend to crash when speculative frenzies end. That’s why it’s a good idea to remain a bystander when prices are rising unsustainably fast.
“Before you make any big financial decisions, please find the most pessimistic person you know and listen to what that person thinks,” Lazerson says. “You don’t have to agree with it, but it will tend to keep you more grounded. We can’t fly forever.”
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