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| The Basics | Are there too many homeowners?
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Risky home loans allow people with poor credit to buy a house or more house than they can afford. Learn how to protect yourself should the housing bubble burst.
By Liz Pulliam Weston
Fed Chairman Alan Greenspan has assured us there is no housing bubble. Consumers arent taking on unaffordable mortgages, lenders arent being imprudent, theres nothing to see here, folks -- move along now.
Forgive me if Im not so sanguine.
I will concede Greenspans point that a nationwide decline in home prices is unlikely. In the United States, we havent experienced such a coast-to-coast phenomenon since the Great Depression.
But I see bubbly local markets all over the country, particularly on the coasts. And the loose lending practices that helped lead to real estate recessions in the past cant hold a candle to the free-for-all were experiencing now.
Some markets riskier than ever
Theres been a huge rise in subprime, zero-down and interest-only loans in recent years. People who would have been laughed out of the bank a couple of decades ago because of poor credit or lack of a down payment are now eagerly sought after, while those with more solid finances are urged to stretch further and further to buy ever more lavish homes.
All this could be putting some real estate markets more at risk than theyve ever been.
Consider:- Nearly 9% of the mortgages made last year were subprime, or made to people with troubled credit or uncertain finances. Thats up from 4.5% in 1994. In terms of volume, $388 billion in subprime-mortgage loans were originated in the first nine months of this year -- more than triple the amount made eight years ago, according to Inside Mortgage Finance Publications, a Bethesda, Md., company that provides news and statistics to the residential-lending industry.
- Zero-down loans totaled more than $80 billion last year. They were virtually nonexistent a decade ago. Another relatively recent phenomenon is the 125% loan. It allows people to borrow more than their homes are worth.
- More than one-third of mortgage applications in recent weeks have been for adjustable, rather than fixed-rate, mortgages. ARMs expose consumers to more risk, because their payments can rise along with interest rates.
- Interest-only loans were, until five years ago, almost exclusively a product for the wealthy, who had plenty of real estate exposure in their portfolio. Now theyre being pushed as a viable alternative for the average Joe -- who is probably underestimating the potential risk hes taking on. (For more details, see Can you handle an interest-only loan?) Interest-only loans now make up 25% of all the loans that are securitized, or sold to investors, and are even being pushed in the subprime market.
Borrowing trouble
These trends worry some regulators and mortgage analysts, who fear that the loans are enticing some borrowers to buy more home than they can really afford. Folks with adjustable and interest-only mortgages are particularly vulnerable: When a homeowner is already stretching to pay the mortgage and the payment isnt fixed, it doesnt take much of an interest-rate bump to make that loan unaffordable.
Theres a lot of concern that . . . these loans are going to go bad, said Andrew Analore, editor of Inside B&C Lending, an Inside Mortgage Finance publication.
And higher interest rates are all but certain. Not only is the Fed raising short-term rates, but a ballooning federal deficit is starting to make bond investors nervous, which could drive up longer-term rates over time.
Faced with higher payments, homeowners who have drained all the equity in their home or who didnt put anything down to begin with are much more likely to simply walk away. The same is true for those with troubled credit. (The serious delinquency rate, where borrowers are 90 days overdue or in foreclosure, is 1 in 12 for the subprime market, versus about 1 in 100 for the prime.)
Which cities are most vulnerable?
A spiking foreclosure rate can set off a vicious cycle in vulnerable markets. Lenders dont want to hang on to foreclosed homes, so they slash the price for quick sales. That depresses the value of surrounding homes, which can wipe out the equity of other, overextended borrowers, who now become more likely to hand over their keys to the bank, which leads to another round of fire sales and depressed values.
Lenders -- and investors who buy mortgages -- get more cautious, as well, once theyve been burned. The easy money starts to dry up and appraisals get more cautious, making it harder to get deals done. Potential homebuyers start to delay their purchases, waiting for prices to fall further, which helps fuel the decline.
This was the cycle that helped drive home prices down more than 20% in Southern California in the early- to mid-1990s and delivered similar blows to Boston, Dallas, Houston and Anchorage in the mid- to late-1980s. All these markets had experienced phenomenal price increases before the helium started to escape.
Predicting which cities are most vulnerable now, though, is tricky. In the past, bubbles have continued as long as the local economies remained strong and populations rose. It took a strong economic shock, such as sharply lower oil prices for Texas or rapid downsizing of the defense industry for California, to really pop the balloon.
Cities that have experienced only modest price appreciation are almost certainly less vulnerable to these kinds of crashes. Its unlikely that Peoria, Ill., or Sheboygan, Wis., where markets have appreciated about 20% in the past five years, could stumble as hard as San Diego, where home prices spiked that much in 12 months. (If you want to see how your city has appreciated, visit the Office of Federal Housing Enterprise Oversights House Price Index.)
Living in a bubble? 4 tips
So what should you do if you suspect youre living in a bubble? Heres my advice: - Dont try to time the market. Prices may crash, or they may not. Even if you truly are living in a bubble market, remember that bubbles can persist for a very long time. People who delay home purchases waiting for prices to drop could be waiting for years -- and perhaps forever.
- Buy only if you can stay put. In normal markets, it can take three to five years for home prices to appreciate enough to offset the costs of buying and selling. If the market really tanks, it can take a decade or longer.
- Boost your equity, if you can. A bigger down payment when you buy, and extra mortgage principal payments afterward, can help you build a financial cushion. If worse comes to worst, prices drop and you lose your job, at least youll be able to sell your home for more than the mortgage rather than suffer a foreclosure, which will devastate your credit. (Before you make extra mortgage payments, though, make sure the rest of your finances are in good shape: that youve paid off your credit cards and other debt, established an emergency fund and contributed to your retirement funds.)
- Consider downsizing now, if that was already in your plans. On the other hand, if you intend to move to a cheaper area or house in the next few years, it may be smart to pull up stakes now. Sure, you may forgo a bit more appreciation, maybe even a lot more. But youll have locked in your profits.
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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