A Fix for the Housing Foreclosure Problem

Any tour of neighborhoods in almost any city or suburb in the country will turn up a house or two where the lawn is unkept, the rain gutters are hanging loose and spiderwebs are being spun in the corners. These are the abandoned and foreclosed homes.

Abandoned and foreclosed houses bring down the property values in the neighborhoods where they are located, and where the lack of maintenance and upkeep makes them increasingly harder to sell, the longer the properties remain uninhabited. Most people understand how this happened: a combination of overinflated housing values that began in the early part of the last decade, along with poor practices by lending institutions where lax underwriting procedures, 100 percent mortgages, interest-only loans and a belief that housing prices would continue to appreciate fueled the push for a continuing cycle of mortgage financing, refinancing, second mortgages and equity lines of credit on inflated home values until the “bottom fell out” and owners began to walk away.

Often, the end result is a homeowner who is “upside down” on his mortgage – that is, where the loan payoff amount is higher than the current value of the house. Additionally, even when the homeowner pays on the loan, he does not see a significant reduction in the loan principal for many years and so cannot “get ahead” of this loss of value. In the “interest first” structuring of the common 30-year mortgage loan, the principal portion of the monthly payment does not exceed the interest (where it becomes greater than 50 percent of the total payment) until over 16 years into the loan.

Under these circumstances, even the most conscientious and fiscally responsible people will begin to wonder why they are trying to make a mortgage payment when they begin to perceive – accurately or not – that “the game” is rigged against them – especially when faced with the added stress of loss of employment, the possible loss of employment or underemployment.

So where is the solution to the problem? Do not look to mortgage lenders and banks, who simply offer the homeowner a new loan at a “lower” interest rate. This may lower a monthly payment slightly, but it also starts the entire 30-year mortgage process over again, where the borrower begins by once again paying the full amount of the interest before any significant principal is paid. In this cycle, the homeowner will probably never have sufficient equity in the property that would give him an incentive to stay in the house. Additionally, the four or five percent “low” interest rates are calculated on the unpaid balance of the loan per year paid on a monthly basis, and if a borrower fulfills an entire 30-year mortgage contract, he will usually pay twice the sales price to the lender for the home.

If you want to solve the problem, especially when you consider that an economic turnaround is probably still some time off, you certainly are not going to improve the situation by keeping the “business as usual” approach that has been, in some part, a cause of the problem. One possible solution is that the existing mortgage paradigm – at least in the case of foreclosed and abandoned homes – must be changed.

First, let us ask the question of why a person would saddle himself with a 30-year mortgage in the first place. The premise at one time was that as home values appreciated, the borrower would make money on that appreciation, even though he would not pay down a significant portion of the loan principal while he occupied the home. The average five percent yearly increase in home values (from 1980 to 2000) was the norm until housing prices became overinflated, borrowing was overextended and the subsequent crash occurred.

So now what? One idea to consider is a flat-rate interest program that would give more incentive for potential buyers to purchase abandoned and foreclosed homes. The idea would work like this: Let us say you have a bank-owned home that has an (independently) appraised value of $100,000. Suppose you could get a loan on this property with a flat 30 percent added to the loan for the lending institution on a 15-year term, for a total cost of $130,000. The homeowner could also keep the standard mortgage deduction on the $2,000 paid every year to the lender ($30,000 divided by 15 years, or $2,000 per year) for a further incentive to buy a foreclosed home.

Now, 30 percent may sound like a lot of money, but let us see how the numbers work out. A 15-year loan is a 180-month term, and the borrowed amount is $130,000 ($100,000 with $30,000 added for the lender). Dividing $130,000 by 180 months yields a monthly payment of $722.22. Using this method, both the monthly payment and the total interest paid would be lower than using the standard 15-year mortgage model when borrowing $100,000 at 5 percent ($790.79, and $42,342.85, respectively), and the borrower would see $555.39 applied to the principal from the first payment on the loan. The buyer would accrue equity more quickly, and after five years of paying on the 15-year loan, he would have 33 percent ($33,000) equity in the home.

Now let us suppose, as is the case in the current housing market, that the value of the property did not appreciate (or even slightly depreciated) over several years. The owner would likely not be in a circumstance where he would owe more on the home than it was worth, as in five years he would have a payoff amount of $67,000. Even if he could only sell the property for $90,000 ($10,000 less than the original purchase price), he would have accrued $24,000 equity. Even in a down market, he would also have a greater incentive to remain in the house and pay down the loan, knowing that each payment increases his equity in the house.

Compare this to the existing mortgage structure, in which a person who has paid on a $100,000 mortgage for five years still owes over $90,000 to the lender because only a small percentage of the payment has been applied toward the principal. This circumstance invites an owner to simply tell the lending institution to take it back and walk away. In the five years that the homeowner has been paying the lender, the lender has made almost pure profit in the form of the interest paid up front, and the homeowner has gained very little.

It is a foregone conclusion that the plan outlined here would not be popular with banks and mortgage lenders and that lobbyists for the mortgage industry would have to be worked around before an idea like this could gain traction in Congress. There is also the question of whether the Federal Housing Administration could (or should) be trusted to oversee a program that would actually benefit the buyer instead of the lender. But one thing is certain: Given the current amount of unsold new homes on the market and the uncertainty about future economic conditions, there is very little incentive to buy an abandoned or foreclosed home with only status-quo financing options available. Banks have shown they will not commit the capital to rehabilitate the abandoned homes on their books in order to make them marketable, and unless the financing options change to one that benefits the buyer of an abandoned or foreclosed property, these homes will continue to deteriorate and become a greater problem for the communities where they are found, with the potential to bring down the value of new homes as well.

 

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Philip Shepherd is an outside contributor based in Seattle.

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