Recently, real estate prices in California reached such ridiculous heights that only 14 percent of the state’s population could afford a median-priced home. In Northern California, only 7 percent could. When the median is out of reach of the middle class, you’ve got a bubble.
So what’s a lender to do when the market peaks and people stop borrowing and buying? He offers loans that make it easy for borrowers to get into a loan … even if they may not be able to make the payments later on.
Here are some of the “easy” loans that could leave you in the lurch later on:
Adjustable-rate loans with low initial rates. “Stated-income” and “no-doc” loans, where you don’t have to prove your income. Interest-only loans that eventually turn into amortizing loans (at which time the payment soars, since it now includes principal). Negative-amortization loans with low initial payments that don’t cover the interest due. The unpaid interest gets tacked onto the loan and the balance grows … even though you’re making all your payments on time.
Lenders are basically lowering their lending standards. But that’s not a problem … for them. After all, loans are sold nowadays. They get the financing fees and the points, discount the loan a bit, sell it off, and start writing a new loan. And let the devil take the hindmost.
Many of these “creative” loans have gotten bad press (with good reason), as rising loan payments are pitted against stagnant or falling market values for properties, leaving uninformed buyers in a bad situation . But the lending industry keeps getting creative. The Newest “Creative” Lending Caters to Keeping Bubble Prices Afloat
Now, in addition to bubble markets that are turning soft, lenders must deal with slacking loan demand due to rising interest rates. So lenders are finding new ways to lower your payments. They’re doing it by stretching out the term.
USA Today reports that Statewide Bancorp in Rancho Cucamonga, California has received a slew of applications since it introduced its 50-year loan in March. That’s right, Five-Oh, as in Hawaii.
Buy that handyman bungalow for just $725,000 and pay it all off by 2056. How could you not?
But beware: The 50-year loans (so far) are adjustable. Still, if you want to go fixed-rate (almost always preferable) and you want to stretch the term, there are now 40-year fixed-rate loans available. Freddie Mac has these loans, some with just 3 percent down (in some cases, zero down) for qualified borrowers.
This is mostly a case of people who make their living in the real estate industry trying desperate measures to keep the bubble afloat. Adding 10 years to your 7 percent, 30-year loan … assuming you keep the same rate (which is doubtful) … would only save you about 6.7 percent on your monthly payments. Yet, it would add nearly $59,000 in interest to every $100,000 borrowed.
With the longer term, it’s likely that you’ll pay a slightly higher rate. So your payment might only come down 4.5 percent a month, or so, according to Freddie Mac. You could end up paying over $70,000 in additional interest for every $100,000 borrowed.
Longer Terms Don’t Make a Bad Price a Good Price
Most importantly, a longer-term loan doesn’t turn the overpriced bubble market property you’re buying into a bargain. It may lower the payments, but it doesn’t lower the price. In fact, it increases the amount you pay over time.
Would I use a 40-year loan? Maybe a fixed-rate one … under the right circumstances … to maximize cash flow on a rental property bought at a significant discount to market value. But, again, that longer-term loan wouldn’t get me to pay more than I otherwise would.
Longer terms don’t make a bad price a good price. Even in a bubble market, you need to follow some general rules of real estate investing.
Get the best purchase price first. Then get the right financing, according to your goals for the property. But think twice before exposing yourself to an adjustable-rate loan – no matter how long the term – especially if you’re buying in a peaking market. Buy value first. Now, I’ve said this before, and it holds true especially in a bubble market. This usually means buying at or below the average-square-foot price … buying at or below the average Gross Rent Multiplier (the sales price divided by rent) … and buying at a price that will cash flow using 80 percent to 90 percent leverage (even if you don’t intend to rent it out). Buy at an early appreciation stage of the market cycle (not the peak phase). And if you’re buying in a market that’s peaking, do so only when you can buy deeply under-market … usually at least 30 percent below market value.
Then … go out and get the fixed-rate money that makes sense according to your long-term goals.
“Let us not bankrupt our todays by paying interest on the regrets of yesterday and by borrowing in advance the troubles of tomorrow.”- Ralph W. Sockman
(Ed. Note: Justin Ford brings a disciplined, long-term, deep-value perspective to investing in both stocks and real estate. His most recent publication, Secret Sunbelt Cities: America’s Best Value Property Markets and the Next Great Real Estate Booms, identifies the next hot markets and helps individuals understand which stage of appreciation their own market is in.)