Our Daily Bleg: A Real-Estate Dilemma

Mike, a 30-year-old engineer, writes in with a real-estate dilemma in which he’s considering a tricky tradeoff: is it worth sabotaging his own credit rating in order to walk away from a house that’s worth far less than his mortgage?

I am hoping he can glean some good advice from those of you who may work in related fields. (Considering your fervent response to a recent post about homeowner bailouts, he probably won’t be disappointed.) Here are the details:

My question is about my current housing situation and when (if ever) it makes good economic sense to walk away from an underwater home. My new wife and I bought our home in Temecula, Calif., as a place for us to start a family, not as a get-rich-quick investment or because we expected the value to go up in the near term. However, we never expected the value to crash the way it has.

We bought the house in early 2007 for $445,000 and put $50,000 down (the lender encouraged us to put zero down, but even though $50,000 was a huge amount of money for us, we felt more comfortable with some equity in the home and a lower monthly payment). So our mortgages totaled $395,000. Now that the market has crashed in our area, our house is worth about $250,000.

Our home value is now about $140,000 less than we owe on our mortgage and our $50,000 down payment is essentially gone. Although our monthly mortgage payments are high, we can still afford to make them, but should we? If we walk away and buy another house with my parents cosigning on the loan (or even just rented a place), we could save almost $1,000 a month in payments and maybe even have positive equity in the next few years. If we stay in our home, we’ll be stuck for many years, and if the market ever does get back to what we paid, the best option we’ll have will be to break even with a sale and then buy another house with an inflated value.

I’m certainly concerned about the ethical side of it, and know that walking away is not “the right thing to do.” But my question is from a purely economic perspective and I’d be saving a significant amount of money by lowering my monthly payments and erasing $140,000 in debt.

Since California is a “non-recourse” state, all the loan company could do is take the house. And the Mortgage Forgiveness Debt Relief Act of 2007 states that through 2012 the I.R.S. will not count forgiven debt as taxable income. So the only financial downside appears to be a destroyed credit rating. Am I missing anything?

So the big question is: how much is my credit rating worth? Is it worth more than $140,000 plus $1,000 per month?

Now imagine a few hundred thousand Mikes, or maybe a few million, and you can see why real estate will remain a mess in many parts of the country for years to come.

How flexible will his bank be in a renegotiation? There is the chance, of course, that his own home will regain its value in time, but that time frame is a big question mark. Some of you may want Mike to double down and buy another house while values are low, but I doubt that is an appealing option.

Please give Mike the best insights you can.

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  1. Matt says:

    If Mike bought the house as a ‘starter’ home in hopes of upgrading later as his earning power grew, then he may have to wait a little longer for that next house. If housing prices grow from this point forward at an average 2% each year (below inflation), and Mike’s got a 30 year fixed mortgage, then he’ll be back in positive equity after 12 years and have his $50K equity back in about 15 years. If he likes the house and can stay, he will eventually get back out from under.

    And over the next 15 years he will have saved about $68K on taxes over renting.

    When the loan is done, Mike will have an asset worth about $430K, that’s a 7.5% CAGR over 30 years. Not bad at all!

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  2. Richard says:

    The interest rates on a recourse loan and a non-recourse loan are different. If one is charged with the non-recourse interest rate (which is higher), why should he/she feel guilty about opting for one of the options under the non-recourse contract?

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  3. Steve J says:

    To Mike — remember why you bought the house to begin with. It is first and foremost, a place to live. You get value from the house as a place to live. You haven’t lost any money yet (you don’t lose money until you sell, remember?). Everyone is running scared now, and panicking. You didn’t mention if you have a job or not. If you have a job and want to continue living in Temecula, then do so, in that house.

    Also, time is on your side. As you live in the house, you are paying down principal. The home prices (being SoCal, especially) will also go up. Maybe not like before, but up. At some point you will hit the break even point, where what you owe is what it’s worth.

    Also see if your parents can help you with a refinance. Now is a great time to do so. Find a mortgage lender who is willing to work with you and your parents. You can probably save several hundred dollars a month. It will be hard, but easier than buying another house after you wreck your credit.

    I lived though the last SoCal housing crash in ’91, everyone panicked, sold, and lost money. Now everyone looks back at that time and says “Boy houses were cheap then, wish I had bought!”.

    Just stay cool. If you lose your job, that’s a game changer. However, If you can still afford the mortgage, wait it out.

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  4. Betty-Jo says:

    Just want some advice about whether we should walk away from our house or not. We bought our house just before the economy went south ! We have lived in our house for almost ten years we haven’t any equity all we are paying now is the interest. We still owe 400,ooo and our loan is conventional is there anything we can do.What would you suggest? Thanks, Betty-Jo

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