Pay Me My Money Down — Bruce Springsteen
In a healthy real estate market, people only take on as much debt as they can afford, and they work to pay it off as quickly as possible. Debt is something to be retired not endlessly serviced.
If you look at the equity curve of real estate, you see that equity is built in 3 major ways:
- Speculation.
- Inflation.
- Debt Retirement.
A truth that everyone is becoming painfully aware of is that speculative equity is not stable. Prices once detached from fundamentals will return to them at some point. The return to fundamentals is either accomplished through actual price declines or a period where prices increase at a rate less than inflation. It is usually the former. Speculative equity cannot be counted on, and it is only captured through careful analysis or blind luck. It is usually the latter.
Inflation equity is really not equity at all. If your house doubles in value in 20 years, but the value of the currency has cut in half, you really haven’t gained anything. On paper you have a gain, but the money you get out has no more buying power than the money you put in, so you really haven’t benefitted as much as you think you have. Inflation equity will preserve your wealth, but it will not add to it.
The real way to make money through long-term ownership of real estate is through obtaining financing equity. You get this by paying off your loan. This method of building wealth, the only one that really works, has been much maligned over the last decade as fantasies of easy money through boundless appreciation gripped the market.
Pay me or go to jail
Pay me my money down
The last time we had a healthy, fairly valued market was from 1995-1999. During this period, people did not believe in endless appreciation because prices had been declining since 1991. Buyers realized the only way to make money in real estate was to borrow a small amount and pay it off or pay such a small amount that you could rent the place for positive cashflow. Once prices start going up, people see that they can profit from appreciation, and the slow, steady method of building wealth through retiring debt seems rather quaint and old fashioned.
Once prices start really going up, paying down mortgage debt is an unnecessary financial burden. Why bother paying an extra $500 a month toward your housing debt when the house is going up in value about $5,000 a month? Why not just use interest-only financing and spend that $500? Well, that is such a good idea, the next step is obvious: why not utilize a loan where you don’t even pay the interest and free up that payment money for consumer spending. The Option ARM is born.
But why be satisfied with only falling behind $500 a month on your mortgage when house values are going up $5,000 a month? Why not borrow more? Why not go withdraw the equity in huge lump sums? After all, it is accumulating far faster than it can be spent. If you refinance or open HELOCs periodically, you can extract this free money as soon as it becomes available. Why not?
Do you see how speculative equity is a slow seducer? The foolish and irrational seems completely logical when you look at the changing circumstances.
When a Ponzi Scheme is built on debt, like it was during the Great Housing Bubble, each person in the chain must assume a larger debt than the person who came before them. Since nobody is paying down debt, and since most people are furiously adding to it, the amount of debt buyers needed to take on in order to pay off the debts of the seller becomes very large. There is a point where the debt becomes too large for people to service, and they default on their payments. Once banks stop getting paid back, they stop making loans: a credit crunch.
The challenge for lenders in the wake of a crashing Ponzi Scheme is to rediscover the debt-to-income levels people can support for residential real estate. Historically this number has been around 28%. The challenge for the market is to endure the crash back to pricing levels consistent with stable borrowing levels. We are in that process right now.
During the price decline, market psychology will also change. People will slowly recognize that the personal financing methods they believed were stable during the bubble (interest-only and negative amortization loans at high DTIs) are not stable and should not be used. As long as market participants believe in the fantasy of speculative equity, they will utilize whatever means of financing is available to them to acquire as much real estate as possible. It is the knife-catcher mentality. The slow grind of declining prices will pulverize this faulty thinking over time, but in the interim, people will continue to overpay for real estate to the degree that they can.
Eventually, it will become widely recognized that borrowing a small amount and paying down a mortgage is the only real method of accumulating wealth in real estate. Of course, when this happens, the market is at the bottom, and the whole cycle begins all over again…
{book}
Today’s featured property is an example of how people get seduced by the free money of speculative appreciation. They were not bad HELOC abusers: a refinance here, a HELOC there, but over time this habit has more than doubled their mortgage obligations, and now they must sell their home before they fall underwater. Are you ready to assume their debts? Whoever buys this house is going to. They took out the free money and spent it, and now they need to find someone willing to pay off this debt before it becomes a short sale.
All their equity — initial, speculative, and inflation — was wiped out by their method of financing and mortgage management. Seventeen years of ownership, and they have nothing to show for it.
Asking Price: $699,900
Income Requirement: $175,000
Downpayment Needed: $140,000
Monthly Equity Burn: $5,833
Purchase Price: $355,000
Purchase Date: 9/18/1992
Address: 14 Deerwood East, Irvine, CA 92604
| Beds: | 4 |
| Baths: | 3 |
| Sq. Ft.: | 2,563 |
| $/Sq. Ft.: | $273 |
| Lot Size: | 5,400
Sq. Ft. |
| Property Type: | Single Family Residence |
| Style: | Contemporary |
| Year Built: | 1975 |
| Stories: | 2 |
| Area: | El Camino Real |
| County: | Orange |
| MLS#: | S558822 |
| Source: | SoCalMLS |
| Status: | Active |
| On Redfin: | 1 day |
 New Listing (24 hours)
|
|
beautifully landscaped back yard with 2 lily ponds,majestic palms and
an Arizona flagstone patio. The 2 car garage enters directly into the
home. One bedroom is on the main floor and is currently being used as
an office. This is a great floorplan with soaring ceilings, a huge
Kitchen, Breakfast Nook, Living Room,and Master Bedroom Suite with a
retreat. The Family Room is connected to the kitchen and has a wood
burning fireplace. Those needing a mainfloor bedroom will appreciate
this plan. The kitchen has white washed oak cabinets and tons of
storage and counter space. Classic French Doors lead from the Living
Room into the garden. Deerfield is a popular, safe family friendly
community with the homes surrounding a gorgeously landscaped 12 acre
park with a club house, 6 pools, tennis courts, volleyball and many
kiddie play areas. Deerfield Elementary was honored with the
distinguished Blue Ribbon Award
That description was not painful to read. Well done.
This property was purchased on 9/18/1992 for $355,000. The mortgage record database I use does not show their initial financing, but we can assume it was a $284,000 first mortgage, and a $71,000 downpayment.
- On 5/27/1999, they refinanced with a $335,000 first mortgage.
- On 6/5/2002, they refinanced with a $379,000 first mortgage.
- On 4/2/2003, they opened a stand-alone second for $40,000.
- On 11/10/2003, they refinanced with a $438,000 first mortgage.
- On 5/3/2004, they refinanced with a $490,000 first mortgage.
- On 5/22/2006, they opened a HELOC for $100,000.
- On 5/1/2007, the opened a HELOC for $160,000.
- Total mortgage debt is $650,000.
- Total mortgage equity withdrawal is approximately $315,000 plus their downpayment.
This is the kind of property I see every day. The owners doubled their debt through mortgage equity withdrawal. They do not meet the definition of a distressed seller, but they need to sell soon before they fall underwater, so they are likely motivated. Plus, their mortgage debt has probably grown faster than their incomes, so they are probably having difficulties sustaining the payments. As I have said before, They Are All Distressed.
If this house sells for its asking price, and if a 6% commission is paid, the owners stand to make $302,096. Out of this profit, they have already spent $315,000, so either this will be a short sale, or they will write a check for $12,904. With their 17 years of ownership, they didn’t make anything. At least the banks won’t lose much money on this one…
{book}
I thought I heard the captain say
Pay me my money down
Tomorrow is our sailing day
Pay me my money down
Pay me, pay me
Pay me my money down
Pay me or go to jail
Pay me my money down
As soon as the boat was clear of the bar
Pay me my money down
He knocked me down with the end of a spar
Pay me my money down
Pay me, pay me
Pay me my money down
Pay me or go to jail
Pay me my money down
Well, If I’d been a rich man’s son
Pay me my money down
I’d sit on the river and watch it run
Pay me my money down
Pay Me My Money Down — Bruce Springsteen
P.S. I thought you might like this video:
Hey, Bernanke, Paulson, and, Bush: Pay off OUR Loans!
“The 2 car garage enters directly into the
home.”
How convenient, they must have knocked out the walls. 🙂
Making money by recovering financing equity? Are you kidding? If I have $100K in the bank and $100K of mortgage debt, do I make money by paying off the debt and having $0 in the bank and $0 mortgage debt? My equity has definitely increased by $100K, but at the cost of $100K of cash. I don’t like being in debt and am keeping my debt levels well within my income’s capacity to service it, but paying off the principle does not make me any money. Now it can very well positively impact my cash flow by jetisonning interest payments, but the curve shown details a normal 30 year payoff.
Obviously, in one day, paying off debt with cash has no impact on your equity, but as you noted, it does have a positive impact on your cashflow.
Some people ignore the obvious with mortgage debt because they think the home mortgage interest deduction is some magical wealth builder.
In your example, if you have $100,000 in mortgage debt financed at 6% on an interest-only basis, you are paying $6,000 a year in debt service. Let’s say the mortgage interest deduction on that nets out to 25%. That reduces your out-of-pocket expenses to $4,500 a year. That $100,000 in the bank may be earning 1.5%, perhaps more if you find some great CD deal. The net cost of borrowing is still $3,000 per year. If you paid off that debt, you give up $1,500 in tax savings, $1,500 in CD interest (which you are taxed on), and you avoid $6,000 in interest expense. In short, you come out about $3,000 a year ahead by paying off the mortgage debt.
If the $3,000 a year is saved, which it would be if locked up in the equity of your house, over time, you would have substantially added to your net worth.
Debt is not wealth. Debt does not create wealth. Debt is a tool that leverages the impact of asset price movements. If that asset is appreciating, debt is very powerful. If that asset is depreciating, debt will wipe you out.
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Perfectly said. It is capitalism and the main reason why it is better for a company to borrow money and have debt: you believe what you are making/selling will be worth the debt and will bring more value/money.
For some business, it works, and owners are happy get rich. For other companies, it does not work and they get bankrupt.
It is normal business life in our capitalism world (the ‘normal’ one, not the crazy financial one).
The funny part is when people who dont understand this debt/equity/growth equation suddenly believe they can use debt like in business for their own personal life without the risk that any company owner knows and assume for his business.
Then it becomes a mess !
With the real-estate-always-goes-up mentality, it made perfect sense to borrow $800,000 you could not afford to service rather than $400,000 you could afford to pay down. When prices all go up 10%, you made a lot more money by borrowing and buying the more expensive asset. Of course, now that prices are crashing, everyone who put money into the deal is losing.
In total agreement. You would not normally pay $1 to get something worth 30 cents, so you need a very sound investment to justify excess home mortgage interest payments. I haven’t seen too many very sound investments in the last 18 months or so. On the other hand, if you can get all your neighbors – via their federal taxes – to take the downside risk for you, maybe your new HELOC boat was a good investment!
“Debt” will not wipe you out, but debt that is unsustainable will.
We’re almost all holders of debt on depreciating assets: car loans. I buy a car with a 20K loan. The minute I drive it off the lot its worth less than that. As I put miles on it, it gets worse still. Yet, somehow, I’m not bankrupt.
I have bought cars with cash and cars on finance. I have bought houses wiht 5 percent down and 40 percent down. Where people collapse is they take debt on speculative equity. If I bought a car for 30K and they offered me a “CELOC” for 40K, that would be a problem…
*With their 17 years of ownership, they didn’t make anything*
They made 3/4 of a million bucks upfront, before they sold this place. And spent it before they sold. Mebbe that should be “17 years and nothing accumulated.”
There are thrifty folks, and just plain spendthrift folks.
I wonder there is only one photo? Is 1975 a good year for home construction quality?
They probably think their house is so special it doesn’t need multiple photos since it will sell in days…lol
Older homes tend to be less energy-efficient. And if this place still has the original windows I bet you can hear the cars rumbling down Irvine Center as well as the train.
With their 17 years of ownership, they didn’t make anything.
They didnt save anything. They MADE ~$300k and promptly spent it all.
Also, what is rate of the inflation equity? Is it the CPI or income inflation/increases?
Anyone know what the historical norm is?
They did not make anything they borrowed 300k off their equity in their home that may not sale for the full loaned amount. So where do these people go when and if they sell? They will have zero money for downpayment after they pay for their loan.
Well in the slim chance they actually saved some of that HELOC $ they could party like it’s 1999.
If they didn’t, time to move in with the kids or rent some crappy apt. in Anaslime or Westmonster.
Because it looks like they’re going to sell the house for $300k more than they bought it, do they have to pay taxes on the $300k?
It was great seeing everyone last night! IR and bloggers, check out this video – just google
“sponsor an executive”. Very funny!
“Inflation equity is really not equity at all. If your house doubles in value in 20 years, but the value of the currency has cut in half, you really haven’t gained anything. On paper you have a gain, but the money you get out has no more buying power than the money you put in, so you really haven’t benefitted as much as you think you have. Inflation equity will preserve your wealth, but it will not add to it.”
That’s only true to the extent you have equity in the property. If you have a No-Money-Down Interest-Only, you’re going to get that inflation equity (assuming you don’t run out and get a HELOC and spend it), and it isn’t going to be tied to any equity that’s been put in. Of course, the inflation is hidden in the interest you’re paying, but you can still gain equity through inflation.
The coming of lower rents has been mentioned many times on the blog. Looks that is new a new reality:
http://www.latimes.com/business/la-fi-rent8-2009jan08,0,5261091.story
Housing downturn hits L.A.-area rents
– Overbuilding and foreclosures add to supply of units as the recession limits what people can pay.
The owner has 2 kids go to USC that’s the reason.
I am quoted in the Wall Street Journal tomorrow, but it is in their paid, online area. Does anyone know how to get around it so I can link to it on the blog?
Will it also be in the print version?
I believe it will be in the print version as well.
The reporter just emailed me telling me it may not run tomorrow and she would keep me posted as to when.
Does anyone know if irvinesinglemom’s subscription can be used to create the link?
I subscribe to WSJ online so, if anybody wants to walk me through how to do this, PM me.
Just curious if anyone knows the history/origination of the 28% DTI ratio. Obviously this was FNMA used for conforming mortgages but I’m assuming 28% wasn’t pulled out of the air, what was the justification for 28% as opposed, say, to 24% or 32%? Plus why not vary with income. For example my cost of food as a % of my income goes down if my salary goes up in normal times (as long as i don’t trade up to Spago from Applebee’s) so maybe someone with above median income can pay above median DTI.
The DTI ratio limits resulted from trial and error with years of of lending since WWII. Allowable DTIs have been creeping up slowly since the 30-year conventionally amortized mortgage became the financing vehicle of choice. The FHA has statistics on default rates for various DTI levels going back decades.
A lower DTI is always better for lenders and borrowers, but the lower the DTI, the less money is financed, so low DTIs are not very popular with sellers. The allowable DTI ratio is a balance between financing enough to consummate a transaction and not burdening the borrower with so much debt that they default.
There are so many factors that go into the determination of whether a recurring payment is affordable for any given family. A household earning twice the median definitely has more “room” in their budget for debt service, but most people live a lifestyle near their means (or above it).
e.g. The Irvine couple earning $180k could relatively easily dedictate 35% of their gross to housing; but this couple is also much more likely to have student loan debt and desire driving cars commensurate with their income/professional level. Therefore, 28% is probably a percentage higher income households should limit themselves to.
When my income went up, so did my food bill. Instead of buying 2 or 3 $5 domino pizzas every Tuesday I go out for fondu or sushi. My husband and I don’t buy bottles of 2 Buck Chuck anymore either, we’ve upgraded to the $7-15 bottles. The transition from being in college-mode to well-to-do happened so slowly I didn’t even notice my food bill increasing.
I just refinanced from a 30 year fixed @ 5.625% to a 15 year fixed at 4.375%. My interest payments will go down about $220/month. So my mortgage interest tax deduction will be about $2600 less next year. Some people would actually consider that to be a bad thing. Paying interest is like shoveling $20s into the fireplace, as far as I’m concerned.
Exactly. The same people who would tell you that you are throwing your money away on rent would tell you that you should maximize your home mortgage interest deduction. Perhaps I should do a post on throwing away one’s money on interest…
Please do. When my oldest brother was still imbibing the Kool-Aid, his argument to me for buying was the huge profit I’d rake in by collecting the mortgage-interest deduction on my taxes each year.
I never could understand how paying out money in the form of large interest payments, only to get a portion of it back every April 15th, was supposed to be an economic boost for me.
Its not. The only “benefit” is you like seeing that big rebate check in the spring. I will admit, I like it too, when in reality all it is is getting my money back from the Govt (they got an interest free loan).
People are funny that way – if every decision in life came down to pure dollars and cents, few of us would ever buy – it makes little sense. Yet nearly all of us on this site plan to buy at some point. We humans are a peculiar species…
A few comments on this:
1. I think people enjoy buying houses because it allows them to inaccurately reclassify spending as investment. In a typical buy/rent decision, I think the mental calculation is:
Rent: $1,000/month consumption
Buy: $1,500/month mortgage “investment”, $300 expenses
In reality, of course, the expenses get underestimated, and the mortgage is mostly interest. So, the real calculation is:
Buy: $300 mortgage equity investment, $1,200 interest consumption, $500 expenses
So, the buyer goes from consuming $1,000/month on rent to $1,700/month. Not surprisingly, $1,700/month gets you a nicer place. And because the buyer mentally files the entire mortgage under ‘investment’, it seems like a ‘free’ benefit. It seems like you got a nicer place and you are investing/saving more. I think this is the core conciet of the average realtor – live someplace nicer and tell yourself it costs less.
2. If you do a post on the mortgage interest deduction, it might be interesting to point out that the value of the deduction is baked into home prices. That is, when the deduction was introduced, all the ‘how much house can I afford’ calculations incorporated it, causing prices to adjust upwards. The deduction really represents a risk – if it is ever revoked, it would cause house prices to adjust down. Similarly, when a company announces a dividend increase, it benefits current shareholders, not those who buy after the announcement.
3. I purchased your book on amazon and read it. Excellent! Extremely well reasoned. You have a gift with charts and graphs.
“If you do a post on the mortgage interest deduction, it might be interesting to point out that the value of the deduction is baked into home prices. That is, when the deduction was introduced, all the ‘how much house can I afford’ calculations incorporated it, causing prices to adjust upwards. The deduction really represents a risk – if it is ever revoked, it would cause house prices to adjust down. Similarly, when a company announces a dividend increase, it benefits current shareholders, not those who buy after the announcement.”
Exactly. I don’t have the stats to back it up, but I’d wager that if researched, one would find that houses went up after the interest deduction was introduced and also after the $250K profit tax-free incentive was mandated. I’ll bet these actions were sold to the public as making home ownership more affordable when all it did was make it less affordable while increasing the commissions of the middlemen who, in turn, are huge political lobbyists.
Another reason to hate Washington, the banks, & the whole REIC.
I support phasing-out the mortgage interest deduction (maybe over 30 years), even though we’ll deduct $43k in mortgage interest for 2008. Government should not be in the business of “rewarding” homeownership and thereby punishing renting.
chris, why did you do a 15 yr and not a 30yr? Wouldn’t your payments drop more??
I’m looking at refinancing from a 5.75 to a 4.5 30yr. My payments will go down $500 a month. I figure I could make interest on the money I save, then throw down occasional biggger payments towards my principle.
I guess my question is, wouldn’t you still be paying more interest every month ( larger payment) in a 15yr oppsed to a 30 yr?
“I guess my question is, wouldn’t you still be paying more interest every month ( larger payment) in a 15yr oppsed to a 30 yr?”
I’ll assume the interest rate is the same. I just looked, and the cited rates for 15 vs. 30 year fixed showed more spread among lenders than between themselves (even restricted to 20% down and 0 points).
The shorter loan has the same initial monthly interest – the initial difference in payment is all principal. As a loan amortizes, the monthly interest decreases. Since the shorter loan amortizes faster, the monthly interest on the shorter loan is smaller for most of the loan life.
The greatly reduced total interest cost (smaller average monthly interest x shorter loan life) is why it is usually a good idea to pay off a loan as quickly as you are able to. (The exception is when you can obtain a better rate of return at similar risk elsewhere.)
OK, I ran the numbers (hopefully correctly) for 15 and 30 year fixed at 5 APR. I’m also giving the interest-only payment for comparison.
IO pmt: $4.07/mo per $1k borrowed
30 yr pmt: $5.30/mo per $1k borrowed
15 yr pmt: $7.85/mo per $1k borrowed
30 yr int: $908.20 per $1k borrowed
15 yr int: $413.04 per $1k borrowed
So the shorter term has a 48% greater monthly payment and 55% less total interest paid.
At higher interest rates the payment gap narrows, and the interest paid gap widens slightly. At lower interst rates the opposite occurs.
Note: I was technically correct that the average interest payment is smaller on the shorter term loan, but this effect turned out to be relatively small.
“The last time we had a healthy, fairly valued market was from 1995-1999.”
I would argue that the last time we had a fairly valued market was when lenders were completely on the hook for losses and the government was not interfering in the market.
I don’t know if that has ever occurred.
IR, would be very interested to hear your thoughts on the breaking news that Citigroup has agreed to let bankruptcy judges adjust the principal on mortgages.
It’s beyond me why everyone is talking about how we need to keep “responsible” homeowners in their homes; if a homeowner were responsible, they wouldn’t have any problem making payments. This is all about keeping irresponsible homeowners in homes that instead need to be allowed to fall to fair value so that responsible homeowners can move in. The only reason neighborhood blight exists in areas with large numbers of foreclosures is that sellers won’t drop prices to market value – largely because of irresponsible efforts such as this cramdown proposal being pushed by our lawmakers.
I used to think like you do on this one, but then I read this enlightening piece from Tanta at Calculated Risk:
Just Say Yes To Cram Downs
“I am fully in favor of removing restrictions on modifications of mortgage loans in Chapter 13, but not necessarily because that helps current borrowers out of a jam. I’m in favor of it because I think it will be part of a range of regulatory and legal changes that will help prevent future borrowers from getting into a lot of jams, which is to say that it will, contra MBA, actually help “stabilize” the residential mortgage market in the long term. Any industry that wants special treatment under the law because of the socially vital nature of its services needs to offer socially viable services, and since the industry has displayed no ability or willingness to quit partying on its own, then treat it like any other partier under BK law.”
Great Post as usual IrvineRenter! Another factor to weigh in when calculating where housing prices should fall to is rent. Rents are falling.
New Article about the phenomena in L.A. (coming to a town near you – soon!)
http://www.latimes.com/business/la-fi-rent8-2009jan08,0,5261091.story
I love the first chart you posted because it shows you what equity is built from: Speculation + Inflation + Downpayment + Principal Amortization.
So, think about it. During the bubble, people used $0 downpayment. Hmm, there goes that part. Now, people are realizing that RE also goes down in price, so little by little we will lose the speculation part of it. Principal Amortization? Are you kidding me, people used HELOCs and Options ARMs, there was no principal amortization. And now, we are facing DEFLATION! 🙂 wow, sounds like “Equity” is in the same realm as the tooth fairy, santa, etc.
Equity is nothing but pure speculation until you make money from it.
IR,
I understand that the “TYPES OF EQUITY” chart is for illustration, but would you say that most of us would forget about this crazy boom within 10 years (also will have many first time buyers then) and drive the housing market up to speculative level for a few years?
Or, as a nation are we going to learn something from this and live like folks did in 40s, 50s, and 60s for a few decades? Just wondering.
FYI, still on the sideline but not sure I even want to buy a house in Irvine any more… Thanks.
I remember after the savings and loan disaster that I thought we would never make that kind of mistake again. It took about 20 years, but we managed to repeat the same lending mistakes. We had about 10-12 years of sanity followed by wreckless insanity. I would say we will do it again, but perhaps the regulations that will be put in place in the next 2-4 years will delay it for a while.
BTW, I have been feeling the same about waiting for a house in Irvine lately. As surrounding cities and neighborhoods crash, the Irvine premium is looking a bit too pricey for me. If I get impatient, or if I give up hope, I will buy somewhere else too.
Crunch the numbers all you want. Having no mortgage is better than having a mortgage. It is just more fun.
Since Oct 1979, when the Fed decided to focus on fighting inflation, paying off a mortgage over 30 years with cheaper money has not had as big of benefit as it once had.
Regarding the interest deduction, there is still a standard deduction. A couple can take a standard deduction of $10,700 without actually paying it out. My husband and I only have deductions of about $4,000 (State taxes and Property taxes) but we get the extra $6,000 deduction for free.
No mortgage equals less risk to the family. There is more flexablity if a job is lost or pay if reduced.
IMO, while most people need a mortgage to purchase a house, keeping a mortgage is not as valuable.
make a pdf of it.
go install a free pdf ‘printer’ (I like http://www.bullzip.com ) and then print the page, using that new printer it installs. It’ll prompt you for a filename.
As far as the legality of that, I’m not sure if you can copy their stuff then put it online somewhere else for free.