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Should I Stay Or Should I Go? When You Owe More Than Your Home’s Worth

by: Jeff Quintin, on August 8, 2011 - Uncategorized

More and more often we are seeing homeowners who bit off way more than they could chew, without realizing it.  Of course, in 2008 when the housing market was booming and mortgages were easier to obtain than a library card, no one could know that a few relatively short years later America would be dealing with one of the worst real estate crisis situations in recent history. 

So now that we have been dipping into the trenches of the market bust and as we head toward rock bottom (but are not quite there) many people are facing the very difficult decision of what to do with their home that is worth less than what it owed on it.

Short Sales; An Option For Many

By now, you have probably heard of the term “short sale” and you may even understand fully what it means.  Almost right up there with “foreclosure”, the term represents a distressed sale or situation where the homeowner owes the bank or lender more than what the property is worth. 

After applications have been submitted, myriad processing takes place, and months and months of careful consideration on the part of the lender, a short sale granted offers middle ground to the homeowner while still allowing the bank to recover some of the monies owed on the property.  During a time when many consumers were literally walking away from their mortgage obligations, the influx of short sales offered a creative alternative that kept the situation at bay.  Homeowners were not ruining their credit to the maximum potential, lenders were able to recover at least some of the balance owed on their mortgages and foreclosure was spared.  Lenders much rather prefer a short sale to a foreclosure because of the intense time, energy and costs involved to litigate a foreclosure. 

Regardless of the seeming relief available from a short sale, the fact is that homeowners engaging in this option will suffer credit dings.  That’s not to say that the damage done to their credit will be as severe as that of having a foreclosure – but for about 2 to 3 years, credit reporting will show the short sale.  For this reason, consumers often find themselves sitting in limbo and afraid to take the next step toward resolution through a short sale.

Case Study; Cold Feet About Credit Crunch

In a nice resort community, a property was bought in 2005 for about $875,000 during the real estate market peak.  Steadily, the value of this property declined [] to where it is today at a maximum value of $640,000.  The mortgage that remains is approximately $700,000 – well above the amount that the property is worth.  If sold, after deducting all real estate transaction costs and other expenses, the seller would net no more than $600,000 – leaving a huge gap and a major loss on all sides. 

The big question:  Does it make sense to cut the losses, sell the property now before the value declines further – or wait the market out until the property regains its value so that the owner can break even?

Keeping in mind that this home is located in a resort location where the annual rental income yields a fair amount, the owner has to decide whether it is worth it to carry the property, its expenses and costs while waiting for it to increase in value. 

Let’s examine the numbers a little more closely:  if the property is worth no more than $625,000 to $640,000 gross, they would end up with not much more than $600,000.  Assuming that they will attempt to sell the home for upwards of $750,000 to recover at least $700,000 at the end of the sale, the chances of a successful sale are next to impossible.  Why would anyone agree to purchase the property for $150,000 more than its net value? 

This leaves the owner with the alternative to consider carrying the property year after year until it does appreciate and recover value enough to cover the mortgage before it can be sold to break even. 

Carrying The Property Till the Market Jumps Back

Here is how this property’s monthly expenditure works out:

Principal paid each month    $4,200
Taxes                                  500
Insurance                             200
Total:                              $4,900

Based on this rough monthly expenditure, this homeowner will end up spending almost $60,000 annually to maintain the property.  Given the rental income that averages about $40,000 each peak season, and taking into account extras such as maintenance, commissions, utilities and miscellaneous expenses, the net is about $30,000 annual rental income.

The equation is simple:  Every single year, the owner of this property will have to deal with $30,000 in negative cash flow, just to carry it through.

Waiting the Market Out – Indefinitely

The amount this property will need to appreciate to break even is $150,000 on $600,000 – a 25% appreciation. Assuming the average annual appreciation in a normal market is about 3%, it would take eight years for the home to appreciate the difference in amount needed to accommodate the mortgage so the owner can break even.  When you factor in carrying the property for eight years while waiting for its value to increase, the total losses incurred are $240,000 just to keep the property alive for that period.

Conclusion; No Sense In Waiting It Out

The numbers speak loud and clear.  Spending $240,000 to keep the property alive, only to wait eight years, allows the property to age and depreciate in the process and simply does not make sense.  In this scenario, clearly the better choice is to sell short while the property has not gone even further down in value. 
No two real estate scenarios are exactly the same.  Whether the variant is in the amount left on the mortgage, the owners’ credit outlook or individual circumstance that dictates the ability to maintain the property – it is essential to understand the options.  While there are not too many alternatives, there are indeed a few ways to manage things during this intense time with lower than average housing values.  Trust your Realtor to sit with you and discuss the options you do have so you can collectively work toward a stronger outlook in the future.