The Financial Planner Who Lost His House
By Luke Landes
Carl Richards is one of today’s best writers focusing on personal finance. Originally keeping a great blog at behaviorgap.com, The Behavior Gap has moved to the New York Times, and early next year, Carl will release his first book. Look for The Behavior Gap: Simple Ways to Stop Doing Dumb Things with Money
Carl’s articles on Behavior Gap and now his New York Times column tend to focus on the psychological aspects of money and are usually centered around cocktail-napkin sketches like the example below illustrating how as investors we expect trends to continue into the future.
Great Expectations - Carl Richards - Behavior Gap
Carl Richards is also a financial planner, and in a recent New York Times feature, he uses an example from his own life to explain how people continue to behave irrationally about money even when they know better. It’s a good indication of why a healthy approach to your finances requires much more than knowing, “spend less than you earn.”
Read More Link On Right
We’d like to think that building wealth is as simple as that, but if that were true, anyone who could do simple arithmetic would be financially secure over time.
While close friends and family were likely aware of Carl’s housing situation a few years ago, he’s just now sharing his experiences with the public. How could a smart financial planner lose his house in Las Vegas? How could someone strangers rely on for financial advice find himself underwater on his mortgages? It’s not such a stretch when you understand human behavior.
We feel comfortable in crowds. When everyone else in our closest circle is behaving a certain way, we feel safe if we are taking the same approach and making the same decisions.
We expect trends to continue (see the sketch above) even though reality often differs. In Carl’s case, he expected — and everyone around him expected — real estate prices to continue climbing.
We trust the professionals. Carl qualified for a mortgage at more than 100 percent of his house’s purchase price, according to his mortgage broker. He wanted to believe the salesperson, despite knowing his fee was based on the loan value. Even against his better judgment, he over-borrowed.
Carl’s story also illustrates how easy it is to falsely judge someone’s financial choices from the outside. Now with clients in dire financial situations, as a financial planner Carl is less likely to judge their choices to spend money. Their continued vacations despite the lack of money in the bank could be what is saving their family — or their lives.
You can get caught up in the excitement when everyone around you seems to be making choices which look crazy on paper but seem to be resulting in short-term success. Carl’s example is the real estate frenzy in Las Vegas in 2003:
It felt a little crazy to be shopping for houses that cost half a million dollars, but my income was growing rapidly. Everywhere I looked, people were being rewarded for buying as much house as they could possibly afford, and then some.
There was this excitement in the air, almost like static. I started to think that if I didn’t buy a house right then, I would never be able to afford one… We’d go to open houses for $400,000 homes and see lines of couples in their late 20s — younger than we were — waiting to get inside.
He refinanced his mortgage, choosing a low payment option that added to his loan balance each month rather than subtracted. Then the real estate market crashed in Las Vegas, and he became underwater on his mortgage.
He could continue to pay but owing more on the mortgage than the house was worth, keeping the house was hurting his finances. Carl wrestled with what he perceived to be a moral obligation to continue paying his mortgage and the moral obligation to take care of his family.
After discussing the issue with other, Carl decided that what he had was not a moral obligation with the bank but a contractual obligation, and he should look at the mortgage as a business arrangement. Any business would reevaluate their financial situation, and if it was a better decision to stop paying the mortgage in order to qualify for a short sale, despite the credit score hit, that’s what he should do.
While this was the logical, mathematical choice, it only became a possibility when Carl felt better about breaking his mortgage agreement. Human behavior plays a larger role than mathematics, even in this case. Again, from the article:
The process of making financial decisions is about more than building a spreadsheet to calculate the answer, because life rarely fits cleanly into a spreadsheet. Our decisions often appear irrational until we understand the whole story.
Would you walk away from your house and your mortgage if you owed more than the house was worth, your loan balance was increasing each month, and you’d be better off financially if you just stopped? I’ve discussed this at Consumerism Commentary in the past, and the results, based on participation from readers, was mixed. Some would, some would not. LINK
Should You Walk Away From a House and Mortgage?
This article was written by Luke Landes in Real Estate and Home. 201 comments.
In the real estate boom, many homebuyers extended themselves financially to buy a house that may have been beyond their means. With the exuberant market, people were encouraged to buy with low introductory interest rates and interest-only loans, the belief that their income would increase to meet their payments, predictions that real estate prices would never fall.
As should have been predicted, adjustable-rate mortgages have adjusted and monthly mortgage payments are higher and income hasn’t increased. More people have fallen behind with their mortgage payments.
With declining home prices and interest-only mortgages, more families owe more on their mortgages than their home is worth. Financially, it could make sense, at least in the short term, to walk away. In this state of negative equity, abandoning the mortgage and the house would actually be financially beneficial.
Here is why:
If the house you purchased for $400,000 is now worth only $300,000, but thanks to an interest-only mortgage, you still owe $400,000, your net worth increase by $100,000 simply by wiping the mortgage and the house from your balance sheet. Of course, if this is your primary residence, you still need a place to live. But from this point you could buy a more affordable house or rent for a while.
There is a major drawback to abandoning your responsibilities. If you walk away, you will trash your credit rating, making it more difficult or impossible to rent an apartment, qualify for a new mortgage, and perhaps get a job.
Freakonomics addresses this dilemma (if it is a dilemma at all):
My new wife and I bought our home in Temecula, Calif., as a place for us to start a family… We bought the house in early 2007 for $445,000 and put $50,000 down… Now that the market has crashed in our area, our house is worth about $250,000.
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.
What should this family do? Are there ethical considerations, or is it simply a question of math? Credit rating aside, the financially responsible option may be to walk away, accept your mistakes, and start over. But if people can simply walk away from their obligations, what incentive is there for people to buy houses they can afford and work hard to continue making payments responsibly?
New laws are now in place to help families facing foreclosure, which should encourage people to choose options other than abandonment. But they may not help every family that finds itself in this predicament. What should they do? LINK
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