Tuesday, September 28, 2004

How to Protect Yourself From a Housing Crash

By JOHN R. TALBOTT, Wall Street Journal

Editor's note: Mr. Talbott's book, "The Coming Crash of the Housing Market" (McGraw-Hill, 2003), examines the dangers homeowners face in the current climate of overpriced housing and overextended credit and analyzes the economic perils of owning or purchasing a home today. Following are steps you can take to protect your home investment, adapted from his book.

Soaring home prices, combined with low interest rates, have lulled U.S. home buyers into a false sense of security. But current economic conditions, combined with the actions of overly aggressive lenders, leave the housing market ripe for a major crash. If one occurs, you could end up owing more to lenders than your house is worth, which is what's known as an "underwater" mortgage.

You might conclude that if home prices decline precipitously, the only thing you can do to avoid losing money is sell your home immediately. If you aren't currently a homeowner, but are looking to buy, you might decide to stay on the sidelines, even as rising prices make you worry that if you don't buy right now, you might be priced out of the market forever.

While withdrawing from real estate might make sense for those who fear a housing crash is imminent, such drastic action isn't your only recourse for reducing your exposure to a possible decline in housing prices. A number of alternatives exist for homeowners and first-time buyers alike, some obviously more difficult to act on than others.

First-Time Buyers

For starters, maybe you don't have to be in such a rush to buy a home. Many young couples worry that they'll be perpetual renters, never fully enjoying the comforts their parents gained from owning their homes or the good feelings of family, friendship and warmth associated with home ownership. If they extrapolate historical housing-growth rates into the future, they may believe that if they don't buy now, they'll never be able to afford a home. Annual housing-price increases for the past 35 years have fueled this belief. As prices accelerated over the past couple of years, the feeling that this was your last chance to buy probably grew.

Housing wouldn't be a risky investment if it wasn't for the extreme amount of leverage we place on our homes. Very few businesses or asset classes can be leveraged as much as a family home. The reason is straightforward. Banks extend enormous amounts of money to homeowners because they know that homeowners will do anything before they let the bank foreclose and take the family home.

Smart borrowers in the business world, if they have to pledge collateral, always try to pledge an asset they view as extraneous and can be abandoned if necessary -- something that isn't essential to run the business. Homeowners do just the opposite. They pledge the most important asset they and their family possess.

Curbing Your Debt Leverage

Prospective homebuyers may acquire too much debt if they pay too high a price for their homes. You might be able to service the debt, but you might have problems repaying it when you sell. Or, you might have paid more than your budget allows. Even if you get a good deal on a house, if its price exceeds what you can afford, you may get into serious trouble with your mortgage payments.

To avoid spending more than your budget allows, don't pay more than three times your household's total annual income. With conventional levels of debt financing, this should give you adequate funds to service your mortgage and have a life outside of your home.

You also can get into trouble with debt by having too much leverage. Radio and television commercials are always advertising mortgage deals requiring only 10%, 5% or no money down. Hundreds of seminars teach investors how to buy real estate with no money down. In the latest sign the housing market is reaching the end of the party, ads are now running for interest-only loans. With these mortgages, your total payment goes to pay interest only; no principal is being repaid.

Buying a home takes a great deal of self-control. An individual or couple shouldn't borrow more than 80% of its value. You should take out a mortgage that allows home prices to decline by at least 20% without the loan going underwater -- or to the point where the mortgage-loan balance exceeds the market value of the home.

For Existing Homeowners

If you are already a homeowner, several options are available to help you minimize your exposure to a real-estate crash, but they all have significant transaction costs associated with them.

You can, of course, move boldly and take the most direct course -- just sell your house. If you choose this route, know that you have several alternatives.

After selling the house, you can live in a rental temporarily in hopes that you time the price collapse correctly and can buy again at the bottom, or you can buy something more modest now. If you rent, you should get a fairly good deal as rents haven't kept up with housing-price increases recently in many metropolitan areas. The Wall Street Journal reported last year that a number of homeowners, convinced that the housing market was a bubble about to pop, decided to cash out and stay out. Instead of buying new homes, they're renting until housing prices decline.

If you decide to sell your home and buy a less expensive one, you'll lessen your exposure to any future price declines and should pocket some mad money to use in case you need to weather other adverse events ahead. Ideally, not only will the price of the new house be lower, but you won't need to take on as much debt to purchase it, meaning your mortgage payments will be lower. Any monthly savings can go into a rainy-day fund.

Still, there are significantly more barriers to selling residential real estate than stocks. It takes more time, requires more paperwork and is a more emotional decision. To reduce your risks in a possible housing-price decline, you may want to consider these less stressful alternatives to selling your home outright.

Managing Your Mortgage Debt

Many homeowners find themselves with too much mortgage debt. Let's define this as more than 80% of the current value of your home, using a conservative estimate adjusted downwards based on how overvalued your particular city might be. If you want to plan for a potential housing crash, you can opt for one of the following alternatives.

First, you could begin to pay more than your scheduled mortgage payment each month. Most lenders allow early prepayment of mortgages, and apply the amount you pay above the scheduled monthly mortgage payment toward lowering your principal balance. You also could make a lump-sum payment on your mortgage to bring it down to a more manageable level.

A second alternative gives you more flexibility, but requires more self-discipline. Rather than prepaying the mortgage with a lump sum or increasing your monthly payments, consider setting funds aside in a savings account earmarked for one purpose only: paying the mortgage in case you experience financial trouble. This way, you control the funds.

Proper debt management isn't limited to just managing the amount of your debt. It's also important to manage interest-rate risk. While waiting for their mortgage to close, new buyers should always lock in the interest rate the lender quoted when they applied for the loan. They also should avoid adjustable-rate mortgage options. And, if you plan to refinance your mortgage, don't take out so much cash that your loan will exceed 80% of the assessed value of your home, adjusting for any current market overvaluation. Also, the money you borrow should be used to repay your existing mortgage, not purchase a new TV.

If you believe, as I do, that today's real-estate market is a house of cards, know that you can prepare for the pending collapse. Consider taking these commonsense steps for protecting your assets if the bottom falls out. Indeed, you can survive and thrive after a housing crash.