Everyone wants to own his or her home outright; real estate ownership, free and clear, is the American dream. Yet, unless you are in a position to wipe out the entire balance of the mortgage on your primary residence, making extra payments to lower the principal balance could lead to financial disaster. That may be hard to believe, but the numbers are convincing. Take a moment to let us illustrate how you can eventually achieve that dream of owning your property while reducing wipeout risk in the event of major illness or unemployment.
Imagine you own a bank. You have two customers – John and Mary – both of whom have own a house appraised at $200,000. John has become a total deadbeat, is up to his eyeballs in credit card debt, leases his car, has almost no liquid assets, and has an unstable employment history. Mary, on the other hand, has excellent credit, and although she doesn’t have a lot of excess savings available, has faithfully made double or triple payments to lower the balance on her mortgage, which now stands at just $15,000. She is eagerly looking forward to the day when she can send that last voucher into the bank and know that her house is totally and completely her own.
Now, imagine that both suffer disaster; perhaps they were in an accident and unable to work or were laid off due to a recession. As the bank, you aren’t going to notice until a payment is missed. You’re really going to perk up and pay attention when sixty days have passed and no checks have been received in the mail. At some point, a threshold is passed where banking laws and regulations require that you recognize it is possible you might not receive any more payments from either John or Mary. Of course, the bank employees want to avoid this because that lowers their reported profitability, lessens the strength of their balance sheet, makes their regulators upset, and gets the owners (or shareholders if the bank is publicly traded) gunning for them to change the situation or risk losing their jobs.
To avoid this, the bank staff is going to take proactive measures to get the loan back on “accrual status” as quickly as possible so that it won’t damage the financial statements. The main way this can be done is to foreclose on the property and auction it to a buyer. Now, sitting from your perspective as the bank owner, who are you more likely to go after first? John, who has almost no equity in his home, or Mary? If you were to foreclose on John, you are going to have to get nearly the full $200,000 asking price to wipe out the loan on your books. If you foreclose on Mary, however, you can liquidate the property at a steep discount very, very quickly and wipe out the full $15,000 loan.
Yes, Mary has been a very good customer. Yes, she has done everything right. Perhaps it’s not fair that she is the first one you would go after but to understand why this is done, you must realize the incentive structure set in place for the employees by Wall Street which is, in turn, a result of investors wanting more profits. Who are the investors? You and me. In our 401k plans, IRA accounts, or just through outright ownership of stocks. It’s the pension fund that pays the checks to your parents or grandparents. It’s the insurance company that needs to generate funds to pay claims. With investors demanding profits, Wall Street doesn’t want to see a bank own a lot of real estate. The employees at your bank will not risk their job by attempting to list John’s house for six months so that he can get a little of bit of equity out of it. They are only interested in protecting the funds they advanced John and he promised to repay. That’s why they turn to auctions. They can’t afford to dump John’s house because the proceeds might not be sufficient to repay the loan. Mary’s house, on the other hand, can be listed for $125,000 at an auction. They get their $15,000 and keep a pristine balance sheet while she loses $75,000 in equity that could have been captured were she able to list the property on the market long enough to receive a respectable offer. “What about John?” you ask. That’s the cruel part. They are far more likely to restructure the payment terms to help him out of the situation because they could then legitimately keep it on the books as a “good” loan. They might offer a balloon payment at the end of the mortgage to lower present payments. They might permit two years of interest-only payments. The sky is the limit and it really depends upon how desperately the bank wants to avoid hits to its profit margins.
How can you protect yourself from this situation?
The biggest defense any investor has against foreclosure is liquidity . Say it over and over again. The bank is not concerned with the amount of money you owe them – just that you continue to make payments on time, without delay. Instead, Mary would have been much better off by taking those double and triple payments she had been making and putting them into a tax-free money market account or fund earning four or five percentage points. Yes, her mortgage rate may be higher but that doesn’t matter because if she is in a decent tax bracket, it’s likely that the after-tax cost of the mortgage interest will wash with the tax-free interest rate she’s earning on this investment fund.
“Why would I borrow money at a net 5% after the tax deduction and turn around and invest it at 4% to 5% tax-free?” you might ask. Liquidity. When hard times hit, it wouldn’t matter what her mortgage was, she could have drawn from that account and easily made the payment until she was able to get back on her feet. In fact, at the rate she had been putting aside excess funds, she could have probably made several years worth of payments!
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Originally Posted by Arcachon
