The Decision Strategist

Disclaimer: I am not a financial professional and this should not be taken as financial advice. I don’t own a house either. I am only discussing what I would do in a situation in which housing prices are dropping, supply is at an all time high, and I was facing a mortgage rate reset.

A while ago I talked recently about the financial and emotional aspects of buying a house, but in today’s market, it’s probably better to consider the decision to sell your house. Specifically, the decision to sell your house if you are having financial problems.

The situation that a lot of people are facing right now is one in which they face reseting mortgage rates that will increase their monthly mortgage payment above what they are capable of paying. The chart below is from an IMF report (pdf link) on world credit that I found through Dr Housing Bubble.

Not all of that is going to default, but if these numbers are any indication, a whole lot of people will be wondering what to do when they get their new higher mortgage bill.

It’s a tough situation. If housing prices were still rising, you could sell your house, pay off your mortgage, and be free and clear.

But housing prices are not rising, they are falling; in some cases drastically. There are really only two options:

Option 1: Sell you house

If someone is in danger of defaulting, they can sell their house. In today’s market they probably can’t sell it quickly or for as much as they paid for it. Since the purchase is recent, they probably have very little equity built up. Selling at a lower price means they are still going to owe the bank the difference between what they paid on the house and what they were able to sell for. That doesn’t include all the commissions and cuts that have to be paid, so it will actually be slightly more than that.

In other words, they are in the same position as they would be if they had rented, only they’ve been making higher monthly payments and still owe a sizable chunk due to the difference in prices. On the other hand, their credit isn’t absolutely terrible, since they avoided foreclosure.

Option 2: Cut and run

Instead, this hypothetical person could just stop making payments and let the bank foreclose on the house. Credit score would go down the toilet for several years, but they’d walk away debt free.

In fact, the result of this option isn’t that different from the first option: they are just exchanging the leftover debt from the difference between the buy and sell prices for a terrible credit score.

So then the question is how much debt is it worth incurring to avoid a bad credit score?

Maybe one of the personal finance bloggers could answer this question. I’m inclined to say that no amount of debt is worth it, and so the second option is an obvious better choice.

Sunk costs at play

Though there is some suggestion of people walking away from their houses (maybe from patrick.net?) , sunk costs are coming into play here in a big way. People will consider all the money they’ve already put into the house, and won’t want to lose that. In fact, the sunk cost effect is much stronger in this situation because of the emotions involved in the idea of owning your own house. The effect will be strong enough to keep most people from giving up on their house until they are forced to.

But if you’re facing certain foreclosure, whether now or a couple of years, and you won’t be able to sell your house for more than you bought it, it makes more sense to me to stop paying now (why sink more money into a lost cause?) and walk away.

qualifier: I don’t really know how the foreclosure process works. Are you still liable for whatever value the mortgage has that the bank can’t recover? If so then it doesn’t seem like it matters much what you do.

-zot

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This entry was posted on Wednesday, October 24th, 2007 at 12:09 pm and is filed under Decision Making, Finances, Real Estate.