EYE ON THE PIE: How home buyers step off a cliff

Why does Indiana have such high bankruptcy and mortgage foreclosure rates? No one knows.

Many say the economy in Indiana has been responsible for our troubles, but other states have been hit as hard and not had the same bankruptcy and foreclosure problems. Perhaps we are a state of dreamers, people who want to own a home but do not understand the obligations we assume.

Our dreams are encouraged by the federal government, which allows mortgage interest and property tax payments to be deducted on our income tax returns. This reduces the cost of home ownership.

The common wisdom is that home ownership is the common person’s best investment, but this is an irrational expectation. Homes should be similar to other consumer durables, depreciating in value over time. Yet we see home prices rise over time. Aside from general inflation, is that because newer neighborhoods are less convenient, have fewer trees, sidewalks and urban amenities than older neighborhoods? The areas where home values decline generally are where schools deteriorate.

Our culture says home ownership is good. If so, why don’t we protect consumers from losing their homes? Why don’t we have extensive mortgage payment insurance? Remember, bankruptcy can hit anyone.

The biggest factor that causes people to lose their homes comes from a shock to their finances. That may be an external shock, such as unanticipated health care bills, loss of a job, divorce, or other calamities that throw people into financial distress. Or the shock may come from an internal source: terms within the mortgage itself that push the borrower over a financial cliff.

Builders and real estate agents want to sell homes. They will lead borrowers (home buyers) to lenders who want to make loans. But the loan may be a trap for the home buyer. Say you want to buy a home but the financial side works only if the adjustable interest rate is 3 percent. You may get your 3-percent loan, but after one year the rate might climb to 5 percent and the next year to 6 percent. That’s double the interest payments you can afford. Off the cliff you go.

Is this legal? Yes. Is it ethical? Well, you got your home and you had a chance to read the papers, didn’t you?

Now here is another trap for the home buyer. How much equity should you have in the house when you buy it? In other words, if the house is worth $100,000, should you put down $10,000, $20,000, $30,000, etc? If you put down $30,000, you would have a loan of $70,000 and a loan-to-value ratio of 70 percent.

The higher the loan-to-value ratio, the more risky the loan for the borrower and the lender. Let’s imagine a $100,000 house with a 90 percent loan-to-value ratio. Suddenly, the owner needs to sell but discovers no one will buy the house at more than $85,000. It happens. The borrower still owes nearly $90,000 to the lender and gets nothing for his/her $10,000 investment.

If the borrower cannot find another buyer, and lets the lender take over the house, the lender loses the difference between $90,000 and the sale price, unless the market recovers.

In 2004, of 32 metro areas in the United States, Dallas had the greatest percentage of loans at or above the 90 percent loan-to-value ratio. In that City of the Cowboys, 35 percent of home loans were at or above that 90-percent figure. Who was in second place? The City of the Colts, at 32.5 percent.

Lending practices, a combination of “excessive exuberance” by borrowers and lenders, in cooperation with real estate agents and builders, may be leading many Hoosiers toward the cliff of foreclosure. Watch your step.