Being “Upside-Down” in a loan is a phrase most commonly used with car loans. It means that you owe more than the car can be sold for. With cars, if you are in this situation, you have to actually bring cash to the table to sell your car.
So if you have an outstanding loan of $20,000 on the car that you bought for $25,000, and you can only sell it for $15,000, you have to come up with $5k to sell the car. You take the $5k hit now, but save on years of monthly car loans that will far exceed $5k.
Regrettably this starting to happen on a somewhat frequent basis with homes. This did occur in the mid 90’s but was unheard of again up until a year ago.
So a home owner buys a place a year ago for $300,000. Lets say he puts 5% down or $15,000 and the loan is for the remaining $285,000. He buys it as a long term investment, but something went wrong: job relocation, divorce, scary neighbors, whatever. He wants to get rid of it and he is faced with a house that can only clear $275,000 due in part because of the market drop and after darn Realtor fees.
That home owner is now “Upside-Down.”
His options are:
1. Sell the house and literally bring a check for $10,000 to the closing and saying goodbye to the $15,000 initial investment. Total loss is $25,000
2. Hold onto it, rent it out, in hopes of a bounce back. (And then really make a killing, right!)
Most people will go with option #2.
There is something about human nature that makes us feel more pain losing $1,000 than the joy of making say $10,000, which we rationalize as deserving. People would rather fight the smallest loss today, even if that means running it all the way down to bankruptcy.
I’ll focus on Option 2 because that is what most people do, but most haven’t evaluated all the pros and cons of that decision. First of all, you have to realize that you are now in Vegas, and you are essentially doubling down your bet. You aren’t evaluating the current situation (“cutting your losses and running”) and instead you are gambling that the future will be better… eventually.
If you are betting on Red in Vegas, just double down! Eventually you will break even right? Even if you are in for $50,000, Red has to hit soon right? Come on Red!!!
While your Red might hit eventually with real estate, you have to be prepared for the worst.
What is your plan?
1. Holding out for the “Spring.”
Hopefully the market will bounce back and you can then take a lower loss or seek the holy grail… breaking even.
Great, yes the Spring is usually better, but usually during an up market. Last year the winter was horrible and the spring just extended that downward. All the houses that sat in the winter were still there, and for a lower price once spring came. The newly listed houses then had to start with a lower benchmark. So waiting might cause your house to go down another $10k-15k.
2. I’ll just rent it! Easy as that!
Ok, but have you run the numbers? Oftentimes you will have as much as a $400 per month discrepancy between your mortgage and your rent. That makes for about $5,000 a year. After 3 years you are $15,000 behind. If the market rebounds great, but if it stays flat, you are now $15k deeper in debt. What if it takes 10 years to recover? It happened in 1990. Also you can’t just count the sales price, you have to consider all the expenses along the way. Oh and ask your accountant, but the tax advantages that you had while owning the place you lived in are gone.
Also I almost forgot, what about that 5 year ARM that is coming due and you haven’t sold it yet and your mortgage goes up 30%?
3. I’ll live in it.
Ok, but I thought you wanted to get out of the place? Your time horizon better be long enough to ride out the storm. If this is just a 1 year bandaid, you might be even worse off in a year (nobody knows, except the National Assoc of Realtors, NAR, of course!). Also if you have a mortgage of $2,000 and you have the option of renting out a smaller place for $1,000, you have to calculate the $12,000 savings a year (but don’t forget your calculate back in your tax advantages).
For some of you, the numbers might leave you no real choice. If you can’t come up with $15,000 to sell it now, you just can’t do it. But for the rest of you, that are electing not to do it because you feel the pain of a $5k loss (or even $50k) is just too much, just be prepared for a worst case scenario in 1 year or 3 or 10 when you wish that you were only $5k behind.
In my blog on Leverage, The Untold Risks With Buying. There is an example of a lady that lost $150,000 over 250 days, I bet she wishes she cut her losses earlier. She couldn’t believe it could go down that much. This is DC!!
My intention is not to scare or depress anybody. I just want to make sure that you have fully thought out what your options are. I can’t tell you where the market is going (see blog on Realtor’s aren’t stock brokers), but you have to be prepared for all scenarios. I know you will hit yourself if you take a loss and the market recovers, but what would you feel if it didn’t and you had to file bankruptcy?
Most Realtors won’t go over the doomsday scenario of above, but it is real. Our job is to make sure you look at all your options and only you can decide what to ultimately do. If you sense a bit of bias in here, that was fake. I just put that in there to counter balance your preexisting biases.
Also read about a DC condo owner that was Upside-Down in the New York Times: Buyers Scarce, Many Condos Are for Rent “Could he rent the condo? Yes, but that option is not appealing, either. Mr. Murphy estimates that the unit could rent for $4,000 a month, far short of the $6,800 a month the condo costs in mortgage interest, maintenance fees, insurance and taxes…”
What would you like to do now?
– Written by Frank Borges LL0SA- Broker/Owner