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Avoid Foreclosure Before It Starts
Rapid real estate appreciation and record-low interest rates in recent years
have driven the national foreclosure rate below historical averages, but many
homeowners are more susceptible than ever to falling into foreclosure if there's
a slight change in the economic climate.
Because of escalating prices, homebuyers have to extend themselves further just to get a foot in the door of the housing market. Many spend far more than the recommended 28 percent of their gross income on housing. And they use creative and sometimes risky financing options like no-down payment, interest-only, negative amortization and piggyback loans, which put them in a much more unstable financial position after they purchase the property.
“The chance of a significant increase of mortgage defaults is definitely on the rise in the U.S.,” said T.J. Marrs, a national real estate author, speaker and success coach. “The basic problem is that many people have chosen to obtain mortgages which have built-in negative amortization. This means that their balances will actually be increasing rather than decreasing with their monthly payments. Additionally, these mortgages will have an automatically increasing payment over a period of time.”
In the past it took a major life event like death, divorce or loss of job to force a homeowner into default. But with their precariously balanced finances, many of today’s homeowners are more easily forced into a situation in which they can’t cover the monthly mortgage payment. After a few months of missed payments, the bank steps in and begins the process of repossessing the house.
“If someone could barely afford the payment due to the high cost of housing, they will certainly be at a greater risk should there be any disruption in economy or in their personal situation,” Marrs said.
While demand continues to outstrip supply, and short-term appreciation continues to skyrocket, homeowners who have missed a monthly payment or two can usually sell their house quickly during pre-foreclosure at a price high enough to pay off the lender and walk away with some cash in pocket. But if supply catches up to demand and appreciation flattens out, homeowners may have difficulty finding a buyer who is willing to pay a price that at least covers the unpaid loan amount.
It’s still financially wise to own a home if at all possible. Real estate has historically always appreciated in value over the long term, and current low interest rates offer an excellent opportunity to jump into the market. However, as with all investments, it’s important for homeowners and future homeowners to be aware of the potential risks involved and take the necessary steps to mitigate those risks.
Anyone who is considering a home purchase or who owns a home that’s not been paid for in full should take the following steps to help lower the risk of falling into default, let alone losing their house to foreclosure.
Live by a budget
A budget creates a structure that prioritizes your monthly income so that you
spend your money on what is most important. It protects you from frittering away
your cash on whims and ending up short on the items that are critical, like a
monthly mortgage payment when you buy a house.
“Very few people manage themselves carefully enough to use an actual budget,” Marrs said. “As every dollar slips through a consumer’s fingers each month, much of this money is wasted. Many Americans fall into the category of having too much month at the end of the money.”
When qualifying you for a loan, your lender presumably evaluates your monthly income to ensure you have enough to live by and still cover the additional housing expenses, namely a monthly mortgage payment and property taxes. But don’t leave it just up to them. Before you buy a house, carefully and honestly determine whether your budget can absorb those additional expenses.
If your current budget can’t handle those expenses, it doesn’t necessarily mean you need to give up your dream of owning a home. Look for ways to free up additional money in your budget for housing expenses. You may need to sacrifice some short-term convenience or creature comforts for the long-term reward of owning a house.
One couple saving for a house decided to keep their $70 thrift-store couch instead of funneling money out of their house savings for the couch they really wanted, which cost upwards of $1,000. They used that money as part of a down payment on their house and were able to buy a couch a couple years later. You can also save a surprising amount of money in small-ticket items like your daily workday lunch. You could pocket at least $100 a month or $1,200 a year just by making your lunch with items from the grocery store instead of eating out for $5-6 each day.
If you don’t have a budget already, track all your spending over the course of one month and use that to create a realistic budget that is consistent with the way you live. You may find areas where you’d like to spend less in order to devote more to your housing expenses. Just make sure you live by those adjustments if you decide to make them in your budget.
Leave a margin for good and bad times
Financial planners typically recommend a 6-month savings cushion, meaning people
should be able to continue to make all financial commitments for six months if
their income is completely cut off. That’s a great rule of thumb, but many
people aren’t there and find it tough to get there because their monthly income
is already stretched to the limit.
But if you want to drastically lower the risk of ever defaulting on your mortgage payments or losing your home to foreclosure, it’s critical that you build some padding into your budget. Even if it’s just a few dollars a month, be disciplined about setting aside cash for that rainy-day fund. If you end up saving enough for six months, funnel that monthly amount toward paying extra principal on your mortgage payment (assuming your mortgage does not have a pre-payment penalty).
If the tough times do hit, and your monthly income doesn’t cover your mortgage payments, don’t hesitate to use your savings to buy some time. That’s what the money is there for – it’s better burn those savings than to incur debt or default on your housing payment. Of course, you’ll need to anticipate when those savings will run out and decide if you can make the adjustments needed to continue living in your house. If not, you may need to make the difficult decision to jettison the cost of owning a home.
Even if you make the decision to sell, your savings will afford you the time it takes to list and sell a house for full market value, ensuring that you get the most out of any equity you’ve built in the house. And you walk away without your credit history tainted by a foreclosure or even a delinquent mortgage payment, which puts you in a much better position to buy another house in the future.
Crunch the numbers
Home ownership rewards you with the independence and happiness that comes from
owning a tangible piece of property that is yours to enjoy. On top of that,
property is a great investment because it appreciates in value over the long
term.
But when you’re borrowing hundreds of thousands of dollars to purchase property, you need to make sure the financial numbers add up before you move forward. If not, it’s possible that you’ll lose the chance to ever own the home free and clear, let alone the chance to yield any returns from your investment.
For example, a home buyer using an interest-only loan or negative amortization loan is making monthly payments that aren’t even enough to pay down the principal, so the principal either stays the same or rises in the case of a negative amortization loan. That buyer is making the assumption that the home will appreciate in value fast enough to offset the amount paid in interest (plus the additional principal if it’s a negative amortization loan).
This gamble may pay off in some super-hot markets with little potential for cooling, but you need to look long and hard at the market conditions before you go out on a limb like that. If the financial basis for buying a house is shaky, you need to be willing to make the tough decision to wait until you’re in a better situation to buy or look for a less expensive house.
“Today, most people are buying too much house, just because they could qualify for the loan,” Marrs said. “I see desperation buying going on all over the country. People are buying for all sorts of the wrong reasons, just because they want to be in the market.”
Crunch the numbers with RealtyTrac’s free loan calculators.
Shop for the best finance options
Just because you need to be cautious about home financing doesn’t mean you
shouldn’t shrewdly shop around for the best loan options available. In fact, the
competition that’s been created from the recent housing boom has given many
potential home buyers a better chance of finding financing that makes it
possible for them to buy a home without sacrificing financial stability.
Investigate the advantages and drawbacks of your different options: adjustable vs. fixed rate and all the sub-options within those two types; the length of term; whether you should pay points to lower your interest rates; and the myriad other options available to today’s home buyers.
Shop around with different mortgage companies to see what they offer you. Consult a trusted real estate professional on which of these options they think is best for you. The right loan can save you tens of thousands of dollars over the long term.
This also applies to current homeowners, who should keep a watchful eye on interest rates and consider refinancing if interest rates drop a bit. Even if you’re comfortable with your current monthly payment, it never hurts to save money. If you ever get in a tight spot, you’ll be grateful that your payments are lower and you can always apply the amount saved toward paying down extra principal.
Anticipate changes and adjust
A lot of life changes occur over the course of the 30 years it typically takes
to pay off a mortgage. Many of those changes will have an impact on a
homeowner’s ability to make the monthly mortgage changes. But if homeowners are
prepared for those changes, they should be able to adjust to them and avoid any
risk of default or foreclosure.
Adjusting to life changes can often be easier said then done. Unfortunately, many of the most significant life changes occur unexpectedly and don’t supply the homeowners much opportunity to adjust. That’s why it’s important to carefully budget and leave a margin for the unexpected.
Bottom line: the best antidote to foreclosure is promptly paid monthly mortgage payments. These guidelines should help you avoid the possibility of ever defaulting on those payments.