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

Popularity: 69%

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I’m getting a fair number of people checking out Buy vs Rent and the accompanying spreadsheet (thanks to a couple of you that have pointed out errors). At the same time, Trent over at The Simple Dollar is talking about the value of having a roommate, which I have a cell for in the spreadsheet.

I think he makes a really good point about the importance of not letting financial aspects dictate your life, especially if you are looking to make a stress-reducing choice but are concerned about the financial implications.

If you are young and looking to buy a house, a roommate can really reduce your costs. But they can also add a lot of stress and headache, even if you don’t own the house you are living in with them.

-zot

Popularity: 6%

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In it’s first (not quite whole) month, The Decision Strategist has posted 34 articles. Here are some of my favorites:

• The What am I Doing with My Life? series discusses how I am attempting to decide what to do in the near future.
• The Buy or Rent? series discusses the benefits and risks of buying a house versus renting, as well as providing a spreadsheet to calculate net worth for each option.
• How to Fight Advertising was my first post about the psychology of marketing and how consumers can turn that on their head. A strangely popular post.
• How to use Paired Comparison in Application Planning describes the process of deciding which task to tackle next as I move on with the application I’m trying to build.

Favorite missed post:

• Housing Pundits and the If-Then Fallacy describes people attempts to manipulate a simple human error for their own benefit. I really thought this post didn’t get the attention it deserved, mostly because these tactics aren’t just used by real estate agents, but also by spouses, parents, kids, and anyone trying to convince you of their point of view.

Thanks for all of you readers, especially those who took the time to leave a comment.

-zot

Popularity: 9%

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It’s not often that I see a fantastic article that is spot on, especially in syndicated media, but The Fed’s Subprime Solution, an opinion piece by James Grant at the New York Times, is excellent.

capitalism without financial failure is not capitalism at all, but a kind of socialism for the rich.

Big Business Bail Out

I’m not a fan of proposals by some presidential candidates to provide a fund to bail out people with defaulting mortgages. But I am really not a fan of the tendency by our federal government to bail out big business. Lenders and other giant credit companies are part of what got us into the current credit crunch, and they should not be able to walk away supported by the public’s tax dollars.

Part of our quest to understand and improve our own decision making must necessarily involve the examination and criticism of other’s decisions. Perhaps more importantly, it must include responsibility for our decisions. As big credit companies come to depend on a public bail out in times of stress, they increase risk and instability for us all, and cost us a lot of money in the meantime.

-zot

ps - If my writing is dense today, it’s because I’ve been reading Equality by Default, an excellent essay on the perils of modernity. The best book I’ve read in several years.

Popularity: 7%

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