Bacon's Rebellion

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Real Estate Bubble Watch: Interest Only Loans

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by

James A. Bacon
in

From today’s Washington Post, “Many Buyers Opt for Risky Mortgages“: More than one third of the mortgages written in the Washington metro area this year are interest-only mortgages, loans that allow home buyers to pay back only the interest while delaying payment on the loan principal for years. Housing prices have gotten so exorbitant that home buyers are turning to these risky mortgages as a way to cut their payments to a level they can afford.

Explains the Post: “The loans are attractive because their initial monthly payments are tantalizingly low — about $1,367 a month for a $320,000 mortgage, compared with about $1,842 a month for a traditional 30-year, fixed-rate loan. If home prices fall, though, borrowers could lose big.”

This kind of flimsy financing is a sure sign of a market top. I was warning about the real estate bubble in November 2003, but I didn’t have a sense then of imminent danger. I do now. (Ed Risse reads the tea leaves similarly. Read his more detailed treatment in “The Shelter Crisis.”) Housing prices cannot increase at a sustained rate of 20 percent per year, as they have in Northern Virginia, or even 10 percent a year, as they have elsewhere, when personal incomes are increasing at the rate of 5 or so percent per year. The collapse is inevitable, and when it comes, it’s going to cause a lot of pain. Many, many homeowners, especially the poor saps who put little money down, will find themselves with negative equity.

There will be tremendous political ramifications, too. Homeowners hate rising property taxes, but they’re willing to swallow them when property values are rising. I may be paying an extra $1,000 a year in taxes this year, but my house just increased $15,000 in value. I can always borrow against my increased equity. Once property values drop, local governments will face a crisis. They will have to increased property tax rates dramatically to compensate for falling assessments. But as homeowners see their net worth shrinking, they will find their taxes to be far more burdensome. Just as a collapse in housing prices is inevitable, particularly in Northern Virginia, so is the political upheaval that inevitably will follow.

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  1. Paul Avatar
    Paul

    Do you really think suburban property values will drop in NOVA? I know people are speculating in land (the first bad sign for property values) but have residential property values ever really DROPPED in a suburban area? I can see them remaining stagnant for a few years…but dropping? I’m not so sure.

  2. E M Risse Avatar
    E M Risse

    Jim and Paul:

    Jim: Thank you for posting the Post story. I was going to but you beat me to it.

    I was going to add that those who refinanced as the rates went down to 5.25% and have refinanced as the rates have stayed low and prices escalated to pull out equity may be in for a shock.

    Some may have gotten comfotable with the whole refinancing process and just said show me where to sign and give me the check. We have good evidence that the home mortgage industry has gotten smart and sneaky. They could not refuse to refinance or they would lose the loan so they have found ways to make money from refinanceing and to slip in clauses that were not in that first refinancing packange that was read with care. (Escalating interest on the included home equity line of credit, penalties and trigger clauses to higher rates for late payment, there are no end of tricks.)

    So Paul in answer to your question is Yes. If enough owners have problems and flood the market the price can drop.

    Never happened? Not since the late 90s in NoVa. Here are the numbers based on sales (s), appraisal (a)and comparables (c) for one dwelling in Fairfax: 1988 new $210k (s), 1991 $295k (c), 1998 $189K (a), 2002 $320k (s), 2005 $480k (c). For most of the period 1992 to 1998 the comparables decreased in value every year.

    The lower values were driven by many things some related to the S&L and the Tech Bubble e.g. employers of tranfered employees to had a home buy garantee and then dumped the units on the market…

    Will this unit go back to or below $189k? Not likely but it could happen. How about the family that just refinanced a similar unit for $469,900 and invested in a second home?

    Happy landings.

    EMR

  3. Will Vehrs Avatar
    Will Vehrs

    I bought a NOVA townhouse 5 miles fromt the Beltway in 1989 for $161,000. In 1996 I had to almost give it away for something in the low $150’s.

    Yes, values can and have dropped. That same townhouse I lived in now lists for $390,000.

  4. Addison Avatar
    Addison

    Fairfax county will add 474K jobs by 2020.

    http://www.fccc.org/files/Fairfax_Futures.doc

    Where will they live?

  5. E M Risse Avatar
    E M Risse

    Addison:

    As we suggest in our last column by 2020 all those jobs will not be in Fairfax or in the Washington-Baltimore New Urban Region if there is not Fundamental Change to create affordable and accessible housing.

    EMR

  6. Ray Hyde Avatar
    Ray Hyde

    If enough owners have problems, the price will drop. The price will also drop if enough similar homes come on the market. I believe this is what happened to Will. Why would someone buy his used townhome when a similar new one, close by, sells for the same price? After the available stock was constructed and sold, rarity crept in and the price escalated.

    A primary driver in today’s home prices is increased government intervention, caused by various special interest groups which has acted to decrease the supply of homes. See the article on recent building permits issued.

    But problems don’t have to be money related, as EMR points out they can be distance related, which of course boils down to money. Or they can be job or medically related, which also boil down to money.

    EMR may be right: without fundamental change those jobs won’t materialize in Fairfax because it will be too expensive. But if fundamental change means living in cubicles constructed over the top of Metro stations, then that represents another sort of cost that (many, some) people won’t accept, in which case the jobs won’t materialize, here. If fundamental change occurs according to EMR’s ideas, (Let’s abscond with advertising and entertainment revenues to fund our schools) the jobs won’t exist at all.

    Addison is voicing the same problem, stated another way. So if you don’t have affordable homes, you don’t get the jobs, but if you don’t have the jobs, you don’t have affordable homes. Sounds like a balanced community problem.

    Probably, not all those jobs will materialize and some will go elsewhere, along with the homes. In the end, the real estate bubble depends on the jobs. Jobs, we have learned as we watch them go overseas, are only worth so much. Accordingly, it is jobs that will set our real estate destiny.

    Not everyone refinances to take out money, some do it just for the lower rate and payments, although the temptation is high. What is the difference, though, between selling and trading down, as retirees do, and spending the cash, or refinancing and spending some of the cash represented by equity? If EMR is right, it’s the difference between inadvertently trading down and deliberately trading down. It doesn’t make any difference, as long as you spend the money rationally.

    If your home has proven to be a good investment, it might be more rational to spend some of the equity and keep the investment, rather than trade down to a (more dysfunctional) abode, as EMR points out.

    If, for example someone refinances to buy a second home, then they have two choices of what to do if a problem occurs. Not necessarily a bad thing. Maybe their second choice is closer to one of those jobs that materialized someplace other than Fairfax.

    There are many ways to approach balance, but none to get there.

  7. Ray Hyde Avatar
    Ray Hyde

    After listening to a story on this topic on public radio I concede that I had no idea how popular no-interest loans are. This actually could be bad.

  8. Anonymous Avatar
    Anonymous

    Real estate prices fell 40% from the high in 1987 until 1995. So yes, even in suburbia prices can’t defy gravity.

    The interest only loans will be the undoing of many of the “real estate never goes down” crowd.

    Those with regular financing or no debt can just ride it out.

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