Our first home was a tiny three-year-old house in a neighborhood of starter homes. It seemed to be about the right price for us. The sellers were divorcing. They were behind on their payments, so it was a distressed sale. They had dropped the price without finding a buyer. Finally, they threw in their appliances. That was when we saw it. We offered even less than they were asking and they snapped up the offer.
The neighborhood had been built during a period of obscenely high interest rates. Many original buyers had only gotten into their homes by financing with late-loaded ARMs, which subsidized lower rates for the first couple of years with higher rates later on.
It was assumed that most buyers of starter homes were in a period of increasing income early in their careers. As their income increased, homeowners should have been able to refinance to more favorable terms or else make the higher payments when they came due. Being starter homes, it was also assumed that many buyers would move on to bigger homes before their payments got too bad.
It actually worked that way for many of the homeowners in our area. But it didn’t work that way for others. By the time we came along, interest rates had dropped dramatically, so we had a relatively low rate. But some of the area’s residents had rates above 24%, due to expanding ARM payments. These people were stuck in a bad place. Many of them actually owed more on their homes than when they moved in.
To make matters worse, home values had not increased, so homeowners would still owe money if they sold their homes. The real estate market wasn’t doing well at the time, so even though many had their homes for sale, few of these homes were being sold, even at bargain prices. Consequently, it was common to see vacant homes going through foreclosure. It was a dismal feeling.
Each of the families that lost their home ended up living elsewhere in situations that they could afford. In each case where a home defaulted or was sold at a distressed rate, somebody else came along that had a better chance of affording the home. By that time, ARMs and late-loaded loans had fallen out of favor, so most people coming into the neighborhood had flat rate mortgages.
Over time, I had occasions to discuss this situation with various parties, including realtors, lenders, home builders, and homeowners. It was interesting to see their various points of view on the matter. This subdivision had been built during a housing boom, despite the fact that it was also during a period of high and increasing interest rates. With more of their monthly payments going to interest, buyers could afford less house than they would have under more favorable interest rates.
The builders that developed the subdivision specialized in smaller, less expensive homes. They easily sold the homes and then moved out of the picture. Lenders working to find ways to take advantage of the high demand for entry level housing came up with a variety of financial instruments, including ARMs and late-loaded loans. Many buyers barely qualified for the high mortgage payments. Many of these bought homes they could ill afford, assuming that somehow everything would work out.
Since rates were climbing, payments went up each time the contracts allowed for adjustments. On top of that, the lower payments of the first couple of years automatically increased after that. Some homeowners saw their monthly payments nearly double over a period of five years. Refinancing didn’t benefit many because interest rates were still very high.
Then the housing market flattened out, as it always does at some point following a boom. People that were in houses they could no longer afford were unable to sell those homes, even after dropping the price. At that point, foreclosures became common in the subdivision. By the time interest rates came down, many people were in too much financial trouble to qualify for refinancing, so foreclosures continued. It took a long time before the market started to pick up so that willing sellers could find buyers.
While all players in this scenario bear some responsibility for the fiasco, the people that obligated themselves to a payment plan they could not reasonably afford were most at fault. They simply should have lived within their means instead of incurring debt that was beyond their means. Next in the blame line are the lenders, who made risky loans. They should have known better. Next come the sellers — the realtors and home builders that directly sold homes. Once the sale was complete, they had their money and were out of the picture. But they had frequently pushed prospective buyers to stretch beyond their means. A salesman with a conscience does not encourage his customers to make purchases that will likely harm them.
Players were punished as stated above. The homeowners that engaged more debt than they could afford suffered the most. Lenders that made risky loans suffered quite a bit in lost revenues and in foreclosure and disposition costs. Realtors and home builders only suffered when the market went flat again and their income stream dropped off. Their punishment was much less direct.
The number one lesson I learned from all of this is that even when it comes to a life essential, such as housing, you must strictly limit yourself only to that for which you can afford to pay. It doesn’t matter how much you want something or how good the salesman is. It doesn’t matter how much you think you ‘need’ it. It only matters whether you can comfortably afford it.
If you can barely afford what you are purchasing, you put yourself in a situation where the least downturn can cause your whole financial house of cards to come crashing down. It’s not worth it. If you don’t like living in what you can afford, you will have to pay the price to develop the skills necessary to earn a higher income.
Not coincidentally, the same rules that make for individual financial stability can and should be applied by governments to make for public financial stability.
Next segment in this series: The Tax Auditor
Past posts in this series:
YM and OPM