Daniel Inviglio had to go and stir up the “are homes investments?” hornets nest again. In order to avoid a 10,000 word debate with Felix Salmon, I’ll try to keep this brief and relatively uncontroversial.
Inviglio makes the false claim that other than a bad credit score a homeowner has no economic reason to not walk away from their home once they are underwater on it. Homeowners have several economic reasons to not walk away from their homes even when they have negative equity:
1. Interest < Rent: If interest payments are less than rent, then it costs you money to move out and start renting.
2. Moving = $: It costs money to move, or to put it in econospeak: there are often significant transaction costs. Renting a moving truck isn’t cheap, neither is the opportunity cost of your and your friends’ and family’s time and energy. You may not pay them, but helping you comes at a real economic cost to them, and people are not indifferent to those costs.
3. Recourse: If the mortgage is a recourse loan, the borrower faces the possibility of losing other assets if the bank comes after him.
As Zingales et al point out in a recent paper, in addition to these economic disincentives to foreclosure, people often perceive high moral costs to foreclosing. According to their survey, 80% of people think it is morally wrong to default. Even when the home is 50% underwater, only 17% said they would default if they could still afford the mortgage. Of course when they actually are in the position to default, people might not behave as they say they would in this survey, but they at least perceive it as a cost. There’s a big debate out there about whether or not it is immoral to default on your mortgage when you can afford to pay it, but that’s neither here nor there. Since many homeowners clearly perceive strategic default as immoral, it’s a cost to many homebuyers regardless of the actual morality of default.
Clearly, foreclosing on a home is not economically costless to a homeowner. For many it is not morally costless either. I kind of thought this was conventional wisdom by now.
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Wednesday ~ February 3rd, 2010 at 11:17 pm
RickRussellTX
“1. Interest < Rent: If interest payments are less than rent, then it costs you money to move out and start renting."
Yes, but few people still have interest-only loans.
And I think the answer is more complex. Let's think of this like a project costing task.
Put aside, for a moment, the equity I might have already paid into the home, or my interest rate, or whatever. For the sake of argument, let's assume all transaction costs are explicit, that is I will be paying people to move my ass.
Option 1: What is the price of staying in my home RIGHT NOW?
I owe a series of payments, and I can calculate the present value of a series of future payments.
At the end, I'll own an asset. The present value of that asset is the discounted present value of the future selling price plus the transaction costs of selling (realty) and moving at that future date. I don't know what that will be, but if I lived in community where houses were abandoned all around me and prices had plummeted 50%, I might be able to make an *educated guess* at the future selling price.
The difference between those two tells me what I have to gain, or lose at the present time if I stay in my home. Obviously, if I can pay the mortgage today and I believe the market will recover, Option 1 is likely to be a sensible choice.
Option 2: Tear up the mortgage and move out. I now owe a series of future rent payments, and I can calculate the present value of those payments up to the same date I pay off my mortgage. I can add in the transaction costs, and add in a fudge factor for credit score problems or "moral hazard" if I like.
Compare the present values of option 1 and option 2. That's how I make the decision. Of course rents are flexible, I can choose my living conditions and tweak the results of option 2. For option 1, I can only guess at future selling price.
There's an Option 3, to sell the house in the usual way. Higher transaction costs (realty), and if you know for sure that your unpaid principal exceeds the selling price of the home, then it can't possibly be better than Option 2, except in the moral hazard sense.
Also keep in mind that many people will have their hand forced — if their mortgage payment exceeds what they can actually budget per month, then they have little choice but to leave.
As mortgage rates reset, they may find that walking out is the only option.
By the way, the reason this is news (again!), is that the rate resets for Alt-A and Option-Arm loans issued during the boom are starting to mature:
http://dailyreckoning.com/the-second-wave-of-mortgage-defaults/
2011 is going to be an interesting year.
Tuesday ~ June 8th, 2010 at 11:34 am
The Moral Responsibility of Homeowners is to Maximize Expected Utility « Modeled Behavior
[...] walking away. Past generations didn’t think of a mortgage like ruthless businessman, but rather felt some moral duty towards repayment. This made lending to homebuyers less risky, and thus kept interest rates down. [...]
Wednesday ~ June 9th, 2010 at 7:45 am
Are foreclosures harming future generations? « Modeled Behavior
[...] and 2) there are other indirect costs to foreclosing, like taking a hit on your credit score. I definitely agree on both points. However, Louis Zingales and his coauthors provide evidence that the social and [...]