© 2015 Shmoop University, Inc. All rights reserved.

CHECK OUT SHMOOP'S FREE STUDY TOOLS: Essay Lab | Math Shack | Videos

Financial Literacy

Financial Literacy

Home Financial Literacy Mortgages Third Floor, Lingerie; Second Floor, Octopus Hotel

Third Floor, Lingerie; Second Floor, Octopus Hotel

So the home is $500,000 in purchase price with a mortgage of $450,000. Over the last 4 years you paid down $20,000 of the mortgage so now you owe $430,000. Feels great, right? You are making progress on that debt payment, and who likes a lot of debt, except for maybe that baby from the Capital One commercials?

But now it turns out that the market value of the home is $385,000. Why does that matter?

Guess what. The economy is tanking and you just got fired.

And there are no jobs in town for a horse-shoer. Or for a UPS driver. Or for anything else you’d want to do. And since you couldn’t throw a 100 mph curve ball, you can’t do that for a living either.

So now what?

You move. Luckily, the friendly boys in brown have a job for you half way across the country. Same pay that you were making but you have to start in 3 weeks. And there is a school district looking for substitute teachers at the same time. Great. Both of you spice (spouses?) can find work quickly.

Kind of a success story, right?

Not so fast.

The “market value” of the home was $385,000 – and when you hear market value, it usually refers to what price the home would close at, meaning it gets listed at $425,000 and a buyer negotiates and you settle on $385,000. But then there are closing costs – you had a few termites, there were cracks in the paint and sidewalk, and 5 grand worth of repairs you were liable for paying. Remember that time you tried to move your piano in through the bathroom window? You had to know it would come back to haunt you.

So we’re looking at $380,000 in your pocket.

But wait! There’s more!

That friendly, smiling realtor who actually got your house sold? She has to be paid as well. Figure about 5% in commish, or $19,000, that comes right off the top of the cash remitted to you.

So now you’re getting even less – you have $361,000 now after selling the house.

And now you go to settle up with the bank – you owe them $420,000 because that’s what’s left on your mortgage. Uh-oh. The banded stack of “IOU”s you try handing them is rejected. Big problem.

An even bigger one is coming – there are early pre-payment penalties that you incur by paying off your loan so fast. Yeah, you missed that fine print on the loan.

Because you told the loan officer that “all you cared about was the cheapest price you could get… the lowest interest rate available…,” you ignored all of the little fine print items that go along with “cheapest.” So one big problem is that if you pay off this loan early, you incur another $5,000 in pre-payment penalties as per the contract.

So you really owe the bank $425,000.

And you just sold the home for $361,000.

425,000 – 361,000 = $63,000 in shortfall. Shortfall; like what you experience when you trip over the cardboard box you’re about to be living in.

In common real estate parlance, you are “$63,000 under water.” How’s them fishes look down there?

So what do you do?

You don’t have the money to pay it off. You have lifetime savings of $20,000, but that money is from investments you had by putting away $500 a year since you were a teen. So it has a low tax basis, meaning that if you sold the $20,000 in stocks you own, you’d show a gain of $10,000 and you would pay $2,000 in taxes to net $18,000. So you could sell your stocks and pay some of it down… but it’s painful to do so.

And it wipes out the nest egg you were keeping for children’s toys and bassinets and other stuff like that, because at some point you wanted to put one through the uprights and have a kid or two or three. Oh, yeah, and that game room you always dreamt of. You wanted to be the only one on your block with a full-size pinball machine in your basement.

So what do you do?

Borrow money from another bank to pay off the loan that you owe the previous bank? Who would loan you money and at what price and oh, by the way, how long will it take you to save $63,000 (after taxes)?
On your salaries - a long, long time. Do you really want to work 5-10 years just to get back to square zero?

So what do you do?

Can you maybe get a seller of another home to loan you money to buy their home? You work out a fancy “second mortgage” arrangement so that the $63,000 you owe is bundled in with your new home’s loans? Maybe. Good luck negotiating a fair price on the new house if the seller is loaning you money… we’ll give you one guess who will have the “hand” in that relationship.

So what do you do?

Can you just walk? That is, you just tell the bank, “We can’t pay. You keep the house. Here are the front door keys and the alarm code. You figure it out yourself.” Well, you can do that, but banks are corporate and legal creatures and they will file all the forms that go with a bank repossession, meaning that if you ever go out for credit again to try and buy a home, say, a decade later, the next bank you ask for money will likely… pass. They might even laugh in your face a little.

Why would they loan money to a deadbeat who didn’t know what they couldn’t afford? You walked away once from your obligations - what’s to stop you from walking away again? Surely you’re familiar with the phrase: “Fool me once, shame on you; fool me twice, I’ll hunt you down and make you sorry?” or… something like that…

So technically yes, you can likely walk. These aren’t medieval times, so they won’t throw you in debtors’ prison and torture you every now and then when the guards are bored. But financially, you’ll be given a kind of death sentence from ever being granted credit again. Just don’t try walking away after putting money down on a Medieval Times restaurant. That Green Knight takes no prisoners.

It’s a tough situation. And it affected millions of Americans in the 2008 - 2009 period; the repercussions are still being felt.

People who Shmooped this also Shmooped...

Noodle's College Search
Noodle's College Search