What's Down Here, Anyway?
Grab your snorkels; we're heading under.
If you've read anything about the housing crisis, you've probably seen the term "underwater" kicking around. It may have you humming the words to "Yellow Submarine," but it has nothing to do with diving or swimming…or really anything remotely relaxing.
Underwater is a nice term The Suits have come up with to describe "stepping in it." It basically means that the market value of your house is worth less than what you owe on your mortgage.
Let's say you bought a $500,000 house with a $450,000 mortgage at a 6% interest rate. That means that you're paying about $27,000 each year for your mortgage. Of course, your mortgage payments are deductible on your income taxes; the government wants people to buy homes, so it gives them a bit of a break on mortgages.
Together, you and your main squeeze make $127,000 a year in income. You pay a marginal tax rate (the highest tax you pay on a graduated tax system): 30%. You file your taxes jointly, which means you don't have to pay taxes on your $27,000 mortgage payments each year. Instead, you pay taxes on $100,000 because the mortgage is deducted.
So your tax rate is 30% and 30% of $27,000 is $8,100 (math!). That means you've saved $8,100 in taxes; after tax payments, that $27,000 you pay is more like $18,900…or at least feels that way.
Got all that?
Now, you could rent a place for $1,500/month (or about $18,900/year)—maybe even less. So why buy? Well, lots of folks like the idea of having a place where they can set up their collection of tiny novelty spoons. And, hey, at $27,000 a year, you end up owning a house that's worth $500,000. Or, if you're lucky, even more.
Here’s Where it Gets Scary
The problem is…house prices don't always go up. Sometimes they go down a little; and sometimes they go down a lot.
If you owe $450,000 and the house is suddenly worth $375,000, you're underwater—and there's no oxygen tank. You're still paying that $27,000 a year in mortgage payments, but now you have no equity in your house.
If you hold on and keep paying, housing prices may increase again, but if they don't, you'll end up paying way more than the house is worth. And what happens if you can't wait? If you lose your job, you might not be able to afford the $27,000 in payments. But if you owe more than you can get for the house, you can't just sell and move somewhere cheaper; you owe the bank money, and they don't care how dire your situation is. (To add insult to injury, they'll charge out extra for getting out of your mortgage early.)
Avoid Swimming with the Sharks
It's easy to point fingers when something goes wrong, and lots of people have theories about why it does: some people might blame the bank for lending people the money in the first place; others might say that you shouldn’t have gotten more mortgage than you could afford.
But after all the doom and gloom, here’s the good news: you can do some stuff to avoid getting caught up in this situation in the first place.
Here's how you can keep your head above water:
(1) Research properties before you buy.
Don't just buy a house because Mort the pug would look adorable in the yard. Check out the neighborhood and research the stats. Is the neighborhood on the way up or down? Are there are signs of trouble (higher crime rates than a few years ago, people moving out in droves, a ghost tour bus parked in front of the house you're buying)? Look for a community where values can go up.
(2) Look for houses where you can earn sweat equity.
It sounds gross, but it just means buying a house that needs some work. Find a nice neighborhood with good property values and then buy the house that the weird shut-in used to live in. Clean up the cat fur, give the house a fresh coat of paint to cover up the claw marks, and take down the bust of Elvis mounted over the staircase. Ta-da! Your property values will increase.
Just be careful: you need to be sure the amount you're putting in to the house is less than the increase in value you'll get out of the deal.
(3) Have extra cash on hand.
Going paycheck to paycheck is never a good idea, but it's even less of a good idea when you're carrying a big mortgage. Having a couple months of mortgage payments in the bank or your sock drawer can come in really handy if you lose your job or run into other problems.
(4) Don’t mistake buying a house for investing.
Yes, your home's value could go up and you could end up paying $450,000 plus interest on a house that ends up earning you $600,000 or more when you sell. But property values can also go down (like, way down). If all your cash is tied up in your house and the real estate market takes a hit, you're in for some sleepless nights. Save yourself the insomnia and invest in other stuff, too: stocks, a 401(k), or that app your grand-pappy is developing for to keep track of bowel movements.
(5) Buy less house.
We're all sold on the idea of the dream home, but that dream becomes a nightmare when you can't afford it. Look for a house that you can easily afford. Your wallet will thank you.