Homeowners with negative equity flirt with foreclosure

by Center for Personal Finance editors

NEW YORK (5/1/06)--The recent wave of creative financing and other economic factors have put more homeowners on thin ice. A recent study estimates that nearly one in 10 households with a mortgage had zero or negative equity in their homes as of September 2005 (MSNMoney.com April 24).

The study of 26 million homes in 36 states and the District of Columbia, conducted by First American Real Estate Solutions, also revealed an even more critical situation for recent borrowers: 29% of owners who took out first mortgages in 2005 were underwater in their mortgage.

For some of these cash-strapped homeowners, one major event--such as getting hit with a layoff, divorce, death, or other catastrophic event--could lead to foreclosure.

Having negative equity in the first few years of a mortgage isn't uncommon, particularly when loan payments are comprised mostly of interest payments. However, looser lending criteria and pricey homes in recent years prompted more borrowers to find creative solutions to be able to afford home ownership.

First American estimates that if home prices fall 10%, almost half (48%) of 2005 homeowners will have no or negative equity.

Option adjustable-rate-mortgages (ARMs) are adding to the problem. Washington Mutual disclosed last month that 47% of its option ARMs at year-end carried negative amortization--a situation in which unpaid interest is added to the loan's balance (Investors.com March 22).

Despite the risks faced by recent borrowers, Federal Reserve research found that most of America's homeowners have plenty of equity--about 57% on average as of the third quarter in 2005 (Signonsandiego.com Feb. 26). Those numbers vary by age of mortgage. About 80% of households with mortgages taken out in 1985 have 75% to 80% equity positions, and 65% of borrowers who took out home loans back to 1990 have 50% to 55% equity.

Some reasons why recent borrowers have low equity stakes include high housing prices, low down payments, "piggyback" second loan programs, and interest-only and payment option plans that--�although more affordable each month--didn't pay down principal debt.

Protect yourself in good times and bad:

Think twice about low teaser rates. When they adjust upward, you may not be able to survive the sticker shock when the inevitable increase happens.

If possible, lock in. Fixed-rate loans--although higher today than in recent years--are still historically low.

Keep tabs on your equity. It's not a good time to recklessly borrow against your home. Try to keep an equity cushion of at least 20%.

Maintain a low debt-to-income ratio. By controlling debt, you'll have more flexibility when financial emergencies arise.

Protect your credit rating. To get the best rates, you need a stellar score. Go to myfico.com or annualcreditreport.com for information about how to order your score.