Rowyn (rowyn) wrote,

Real Estate

chipuni posted a short essay on home loans and the current real estate market. Some of the comments to his entry suggested to me that there's considerable confusion about how home loans work in America -- which isn't surprising, given that it's a confusing topic.

I'll start with the juicy stuff:

In some part of the country, couples with an income of $70,000 are able to get loans for $500,000 houses with no money down

This statement may exaggerate the general state of the lending market, but I find it reasonably credible. The mortgage department of my own bank commonly makes loans with 5% down. The rule-of-thumb for qualifying for a loan is that your total debt payments should be no more than 36% of your income. There's no way our hypothetical couple could have that sort of debt ratio on that kind of house, but the debt ratio isn't a hard-and-fast rule. If your credit history is excellent, you can qualify for unusual terms, like no down payment and high debt/income ratios.

It's also possible -- even likely -- that the hypothetical couple is buying an owner-financed home. That means that the seller is either lending the couple the money directly, or is personally guaranteeing their loan (and the bank is looking to the seller, not the buyers, as their primary source of repayment.)

The only way a bank would agree to such terms is if the bank wanted to foreclose

Given that the lender is lending a 100% on this loan, it's highly unlikely that they want to foreclose on the property. If the lender really wanted to be a real-estate mogul, they could buy the property outright and save all the closing costs and hassles associated with foreclosure. Moreover, almost all primary-residence home loans are done through Fannie Mae and Freddie Mac.

The foreclosure scenario changes slightly with an owner-financed loan. Those cases are essentially rent-to-own deals, and the seller may well not care that much if he has to foreclose. If the seller is looking at eventual foreclosure, he may have inflated ether his sale price, his interest rate, or both. He could be thinking of the buyers as tenants that are responsible for paying real estate taxes, homeowners insurance, and repairs.

Frankly, I'd be a little surprised to hear of a seller of $500,000 homes with this attitude -- the rent-to-own phenomenon has been mainly restricted to low-income families and cheaper houses. But it's possible.

There's no way a couple making $70,000 could afford a $500,000 home loan

Let's look at this.

CNNMoney has a fairly good mortgage payment calculator. I've picked this one because they include real estate taxes, insurance, and PMI on their calculator. Any standard home loan (ie, one done through either FM) will include all three as part of the payment.

"PMI" is "Private Mortgage Insurance" or "evil", as I like to think of it. PMI is provided by a third-party insurer, who covers the additional risk that a lender assumes by making a loan for more than 80% of the home's purchase price. Basically, it means that if the lender gets stuck foreclosing, then the insurer covers the difference between the loan's current principal balance and the lesser of either the sale price on the foreclosure, or 80% of the home's original appraised value. This still doesn't make foreclosing attractive, just less painful. If PMI providers thought the bank was likely to foreclose, they wouldn't offer the service. For the borrower, PMI has no value whatsoever, other than meaning "I didn't have to make as large a downpayment".

According to CNNMoney's calculator, our theoretical $500,000 loan at 6% for 30 years has a monthly payment of $4015. About $3000 of that is principal & interest, $935 is taxes & insurance, and $80 is evil, I mean, PMI. (That PMI amount seems awfully low. I'm not sure the calculator's got it right.) For insurance, I've used .75% of the purchase price. If you can find insurance for a $500,000 that's just $500 annually, you're a cleverer person than I am.

That leaves our couple with about $22,000 for all other expense, including taxes. Now, they get a fat tax deduction of about $30,000 for interest on the home loan, and the standard deduction for a couple is, I dunno, around $8,000, I'll guess. I'm too lazy to look up the calculator for taxes. Let's say $32,000 at 20%, for $6,400. So $15,600 for all of our couple's other expenses. Can two people live on that? I'd say "yes, if they're frugal." I've certainly lived on less -- including the cost of rent.

But ...

Why would people who bought a $500,000 house be frugal with the rest of their life?

Because $500,000 is the standard pricetag on houses in some parts of the country. For example, the whole of southern California. If that's the going rate to live where you work, you pay it.

Isn't $500,000 a ridiculous amount of money for a two-person home?

Well. Yes.

Many people believe that the real estate market for the whole of the US is presently in a bubble. This is especially evident in parts of the country like, say, southern California. I know at least one person who thinks that real estate in California is reasonably priced, and I would be delighted to hear any arguments to the effect that we're not looking at a real estate bubble ready to pop. After all, I just bought a house (not, granted, in CA). I'd love to hear that was the right thing to do. :)

But my gut sides with those who say "bubble". A decade ago, the standard home purchase was for about 3 times the annual income of the buyer(s). Now, in parts of the country, it's 7-8 times the annual income. That's ... a big jump. It doesn't look sustainable to me.

So what possesses a bank to lend borrowers 7-8 times their annual income?

Fannie Mae and Freddie Mac do. (There's a difference between the two, but I can't remember what it is right now.)

The FMs are GMOs: government-mandated organizations. They are, strictly speaking, for-profit corporations. They are not government owned or operated. But they were set up under a government mandate intended to encourage home ownership, particularly among low-income people.

They have sprung from this to doing the vast majority of all primary-residence home loans in the US, for borrowers at all income levels. If you have a low-interest rate home loan, it was almost certainly obtained through the auspices of one of the FMs.

The FMs are not exactly lenders. Here's how the average home loan works:

The buyer goes to his local bank and applies for a loan. The bank accepts his application and passes it on to an FM. The FM spits possible terms back to the bank. The bank offers terms to their borrower; the higher a rate they can get the borrower to accept, the more FM will pay them for the deal, and the bank gets to keep certain of their loan fees. The borrower accepts the loan, the bank prepares the docs, the loan closes and the bank funds it. The bank turns around and sells the loan to FM. FM turns around and packages this loan together with hundreds or thousands of other loans, and sells it on the stock market as a mortgage-backed security. Mortgage-backed securities are considered very low-risk investments, and are bought in large quantities by mutual funds, retirement funds, individual investors, and banks.

Following me so far? No? Good.

Who ultimately pays if borrowers default on their loans?

If it's just a few loans, I believe it'll be the FM or the original bank. (The bank can get stuck with the tab if they didn't cross all their t's and dot their i's on the paperwork). This might come directly out of the yield on the mortgage-backed securities, but I don't think that's what happens.

If there's a massive wave of defaults -- as could happen if we are in a massive real estate bubble and it pops -- then there are two possibilities:

1) Fannie Mae and Freddie Mac go belly-up, taking all the investors in mortgage-backed securities with them. This is what's supposed to happen. All investments are only as good as their underlying payor. If borrowers don't pay back their loans, and you own those loans, then you don't get paid. Stinks to be a lender.

2) The US government rides in to the rescue and saves the FMs and their investors. This is what almost everyone expects to happen. It's not supposed to happen. The feds do not insure mortgage-backed securities, and the FMs are not government entities. They are supposed to live and die like any other private organization. But most people think of the FMs as either "too big to fail" or "effectively government entities".

My own bet is on (2), though I'd be much happier with (1), and happier still with "massive wave of defaults never happens". Make no mistake: whether it goes (1) or (2), the economy is going down with it. Way too many people have put their faith in mortgage-backed securities as a stable financial instrument. If that faith is misplaced, we are all going to be hurting.

But the borrower is the one who's really screwed, right? And it's all the lender's fault!

I'm not sure quite why everyone thinks this, but the majority of respondents to ChipUni's thread seemed convinced of it.

If you buy a house with no downpayment, and it turns out to be too expensive for you, then you have several options:

1) Sell the house. Assuming you can get what you paid for it, you're out the real estate commission and loan fees, which is going to be a large chunk of change. If you can get much more than you paid for it -- hey, you win!

2) Default on the loan and let the lender foreclose. Your credit is wrecked and you lose any equity you had in the house -- but that's not going to be much because you didn't have a downpayment anyway. Technically, you are liable for any portion of the loan that the sale of the house doesn't cover, but usually you can settle with them for paying some fraction of it.

3) Declare bankruptcy. That stops foreclosures and ties everything up in court for a while. Depending on your state laws, you may get to keep your house, but if you've got a $500k loan, probably not. Your credit is even more wrecked than with (2), and the court will sell off your assets over a certain amount, and order monthly payments on your debts. In most cases, you will wind up paying some fraction of what you owe, but not all of it.

None of these options are terribly attractive, I know. But none of them look like sweetheart deals to your lender, either. (Though (1) is fine from their perspective.) In most cases, the lender has a lot more at risk here than the borrower. The borrower didn't give $500,000 cash to anyone: the lender did. When the borrower doesn't repay the lender, the lender is the one out the money.

The people who profit most in a bubble are the ones lucky enough to sell before it pops. Does luck make them evil? How does the seller know it's a bubble? Obviously, the buyer didn't, or he wouldn't have bought.

Of course, the big trouble with me and this whole argument is that I'm a good little libertarian, and I think that if someone offers to lend you money and you accept it, then you and your lender are both equally responsible for the consequences of this action. Yes, if the lender has information that they are deliberately keeping from the borrower that would materially affect the borrower's decision, then the lender is at fault. But it's just as possible for the borrower to withholds information from the lender that the lender needed. ("Oh, didn't I mention I planned to quit my job right after getting this loan? Whoops! My bad.")

Fannie Mae and Freddie Mac and banks and everyone else in this equation are certainly guilty of greed. They're out there trying to make money. But they're trying to make money by making it possible for people to buy the houses they want to buy. The lenders are not putting guns to people's heads and saying "BORROW TOO MUCH MONEY OR DIE!" People come to them with these requests. These potential borrowers get dozens of pages of documentation explaining how the process works, and what they're getting into. They have the opportunity at any time to say "No."

If that hypothetical couple I started this with really wants to make this deal work, then they can. Is their lender the bad guy for not saying "No, you can't buy your house, sorry. Good luck finding a rental for less. Or finding a job somewhere cheaper"? Or is the lender their hero for helping them get what they want?

Or are all parties just doing what they happen to think is in their own best interests?

Yeah, I really think it's that last one.
Tags: economics

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