The Basics
The negative equity epidemic
All those ARMs and teaser rates are coming home to roost. 1 in 10 homeowners has no equity or is even 'upside down.'
By Liz Pulliam Weston
Rhonda is in a panic.
The two-year introductory rate on her adjustable mortgage is about to expire and send her payments soaring. She thought she could refinance to a more-affordable loan, but the rates she's being quoted are just as high.
"So I then decided I would just sell the house and get out of it," Rhonda wrote in an e-mail. "WRONG! The houses in my area are selling for around $20,000 less than what I owe!" Find a loan that's right for you at the Loan Center
Rising interest rates would put a strain on homeowners with adjustable-rate mortgages in any economy. But the situation is growing critical for millions of borrowers who are "upside-down," owing more on their homes than they're worth.
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Many of these homeowners may soon face a "can't pay, can't sell, can't refi" situation that could lead them to lose their homes.
Consider:
Nearly one in 10 households with a mortgage had zero or negative equity in their homes as of September 2005, according to First American Real Estate Solutions, an arm of title-insurance company First American Corp.
The study of 26 million homes in 36 states and the District of Columbia found that one in 20 home borrowers was upside-down by 10% or more.
The situation is even grimmer for recent borrowers. Of those who bought or refinanced homes in 2005, 29% had zero or negative equity, and 15.2% were underwater by 10% or more.
Interest rates on about a quarter of all mortgage loans outstanding, or $2 trillion, are scheduled to reset this year and next, according to Economy.com. Homeowners who opted for extremely low teaser rates in recent years could see their payments eventually double, said Christopher Cagan, First American's director of research and analytics.
Defaults and foreclosures are already on the rise, thanks in part to higher interest rates, cooling real-estate markets and overextended borrowers. Nationally, 117,259 properties entered some stage of foreclosure in February, according to foreclosure-monitoring firm RealtyTrac, a figure that's up 68% from February 2005.
Submerged
Any homeowner with negative equity is at risk of foreclosure if hit with a job loss, divorce, death or other catastrophic event. But homeowners with no equity and adjustable-rate mortgages face additional risks from the loans themselves, since their payments could rise 50% or more in coming years as interest rates reset to higher levels.
In addition, borrowers with adjustable-rate mortgages are more than twice as likely to be underwater on their loans as those with fixed-rate mortgages, Cagan found.
Adjustable-rate borrowers have less equity
Equity level Fixed-rate Adjustable-rate
Less than -5% 5.2% 12.3%
Less than 0 7.2% 17.0%
Less than 5% 10.1% 23.1%
Less than 10% 14.0% 30.6%
Less than 15% 19.0% 39.1%
Less than 20% 24.9% 47.8%
Source: First American Real Estate Solutions
Borrowers who chose ultra-low teaser rates of 1% to 2% in the last couple of years could be among those most at risk, Cagan said. One in five such borrowers who took out loans in 2004 and 2005 was underwater as of September. These borrowers face the sharpest payment increases as their loans reset to market rates.
A 1% teaser rate on a $300,000 mortgage that rose to a market rate of 6%, for example, would increase a family's monthly payment by 86%, from $965 to $1,799 a month. If the old payment represented 30% of a family's gross income, the new payment would represent over 55% -- a squeeze that few families could endure for long, Cagan said.
But even borrowers who opted for more-conventional loans could face unaffordable increases. Rhonda's rate, which was fixed for two years at 7.8%, is scheduled to rise to nearly 10% and will continue increasing every six months for the foreseeable future.
The pressure on borrowers' finances will be so intense, Cagan said, that many will lose their homes. Cagan predicted that one in eight homeowners with adjustable-rate mortgages that originated in 2004 or 2005 eventually could default.
Little chance of national rout
Big upticks in foreclosures have repercussions that extend beyond the families that lose their homes. Lenders that wind up with too many foreclosed properties may cut prices by up to 20% to sell the houses quickly, which can depress house values in surrounding neighborhoods.
For a glimpse of what could happen, take a look at Michigan. Foreclosure rates there have soared as the auto industry sheds jobs and reduces paychecks. One of every 408 Michigan homes was in some stage of the foreclosure process in February, RealtyTrac said.
The uncertain local economy and a huge inventory of unsold and bank-owned homes are depressing real-estate values throughout Michigan.
When Robert Darmanin refinanced his mortgage earlier this year, for example, he was told his home was worth $12,000 less than a year ago. His appraiser said her situation was even worse; her home had lost $20,000 in two years.
"We had all gotten so used to house appreciation," said Darmanin, director of corporate relations for LaSalle Bank in Troy, Mich. "It's quite shocking."
Dropping home values put even more borrowers underwater. If home prices nationally were to fall by 10%, Cagan said, nearly half of last year's borrowers and 17.7% of borrowers overall would owe more on their homes than they're worth.
Cagan, however, doubts we'll see a nationwide real-estate rout. If defaults rise to the level he predicts -- about $110 billion, or 1% of total homeowner equity, spread over five or six years -- economic growth might slow by about 10%, he said. Regions that have strong local economies and that aren't overbuilt should survive the defaults without falling into real-estate recessions. Liz Pulliam Weston‘s newsletter
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"It won't break the market," Cagan said, "but it will be painful for the homeowners involved."
How to hang on
If you want to make sure you can hang on to your home in good times and bad, consider the following:
Avoid risky loans. Low teaser rates may sound appealing, but you may not be able to survive the sticker shock when the rates eventually adjust upward. If you're considering an adjustable-rate loan, check to see how far your payments could rise in the future. Don't rely on the assurances of a lender or broker that a loan won't hit its caps --nobody has a crystal ball.
Consider locking in. Fixed-rate loans have moved up from their generational lows, but they're still low in historical terms.
Protect your equity. Now is not the time to be draining your home's value through reckless home-equity borrowing. Aim to keep an equity cushion of at least 20%.
Control your debt and protect your credit. Even if Rhonda had enough equity to refinance, her high debt-to-income ratio would prevent her from getting the best rates. The borrowers who will have the most flexibility to refinance are the ones who keep their overall debt loads down and who maintain sterling credit. For more information on ways to burnish your credit scores, see MSN's Decision Center on credit ratings.
Liz Pulliam Weston's column appears every Monday and Thursday, exclusively on MSN Money. She also answers reader questions in the Your Money message board.
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