Money Obedience

We are living through some interesting times, aren’t we? One of the key areas of these “interesting times” is the housing market. Let’s just take a look at how real estate values have evolved during the last year. Recently the last reading of the Case-Shiller Home Price Index was reported and showed that house prices dropped 18% between December 2007 and December 2008. That’s a big drop.

Let’s see how such price declines impact a house purchase. In the “old” days when you wanted to buy a house, a bank would ask you for a down payment of 20% of the value of the house. When house prices increased year after year banks did not ask homebuyers to put down even that much. Investments in real estate were considered “safe”. But as we all know by now, things have changed in the past two years. Today, again, a bank requires at least a 20% down payment. But considering the current price declines, these 20% do not seem to be that much.

But think of the implications in today’s market. For argument’s sake, let’s say a year ago you bought a house for $200,000. You put down 20%, which is $40,000. That means you took out a mortgage of $160,000 to finance the purchase. This is how it is normally done and, surely it’s conservative enough. Or so you would think. But now, let’s say that a year later the price of your house dropped by 18%. That means your house is now valued at $164,000. That’s the same amount as your initial mortgage. Do you know what that means? You have lost your entire equity value during this year. Your money has just disappeared, for one, and second, the bank has just lost its cushion against you defaulting on your mortgage. This is not a good situation to be in – not for you nor for the bank. If prices continue to decline, you will soon owe a lot more than the value of your house! But let’s not go down too far on that road, because things can get really scary – even for people who are running their personal finances conservatively. (Let’s just say that this can explain to you why it is that some people are simply abandoning their new homes!)

This scenario shows us very clearly what the problem is with debt. Debt gets whittled down very slowly under normal circumstances. In the case of most mortgages, it takes 30 years of continuous working and payments for the homeowner to pay the loan back. But the value of the asset you acquired with the loan or mortgage fluctuates almost all the time. (Housing prices don’t stay the same, or go up all the time, as many of us once believed.) The value of the asset can even decline quickly! But the value of the debt supporting this asset declines only slowly – that mortage doesn’t change so quickly, does it? What this means is that it can easily happen that you are left with a lot more debt than assets at some point in time. In fact, you could end up with a negative net worth even when you financed the initial purchases of your assets in a prudent manner.

At the same time, we have to recognize that debt has its purpose, too. Most of us could never afford to buy a home if we could not get a mortgage to purchase a house and if we had to pay cash up front for a house before we could live in it. By that same reasoning, some of us could never afford to buy a car if debt financing for new and used cars were not available. Some could not afford higher education if student loans were not available. So debt can be okay and even useful in some situations.

The crucial point is that debt has to be used in a sensible way. And even then, extraordinary circumstances – like the ones we are witnessing right now – can get prudent people into financial difficulties. When we live through “interesting times” like the current era of financial strain, our stress level as a community and as individuals increases. There is really not much most of us can do about this except buckle down to survive the dire economic times. If we manage to hold on, we’ll be in a position to enjoy the better times when better times next come around.