How Risk in the Housing Market Affects Home Buyers

Risk Management in the Construction Industry - Navigating Housing Market Risks

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Credit Sesame discusses growing risk in the housing market and suggests how consumers may consider them in decisions about home buying.

A recent study of mortgage activity suggests lenders are taking more risk. This echoes other data that suggest the housing market has gotten riskier in the past couple years.

Real estate information firm CoreLogic found several factors indicating that mortgage lenders have lowered their standards this year. This may be to make up for slowing demand. Separately, home prices and consumer default rates are signs that there is more risk in the housing market.

These developments have significant implications for the economy, but can affect individuals. Anyone considering buying a home should be aware of growing risk in the housing market and the implications for buying a home.

High loan-to-value ratios

Loan-to-value (LTV) ratio is the percentage of a home’s value that a mortgage loan represents. Buying a home usually requires a down payment and the rest is funded by a mortgage loan. For example, a $200,000 home may be paid for with a $40,000 down payment and a $160,000 mortgage loan. At the point of purchase, $40,000 represents your personal investment or equity in the home. The LTV is 80%, calculated by dividing the mortgage loan amount by the value of the home ($160,000 divided by $200,000 in this case).

The smaller the down payment on a house, the higher the LTV ratio is. For example, a $200,000 home paid for with a $20,000 down payment and a $180,000 mortgage loan has an LTV of 90% ($180,000 divided by $200,000).

Lenders prefer lower LTVs so that, in the event they must repossess and sell the home, it is easier for them to recover the value of the mortgage loan. A high LTV ratio is riskier because the property must sell at a higher price to repay loan. A lower LTV ratio gives the lender more of a cushion to make sure the value of the home stays above the amount the borrower owes on it.

A high LTV ratio represents more risk for the home buyer as well. A lower LTV ratio means you start out with more equity in the home. Having equity gives you more financial flexibility to refinance or take out a home equity loan.

A high LTV also means you risk having the value of your home drop below what you owe on it. In that case, if something came up that forced you to sell the home, the proceeds would not cover the loan balance.

It is more difficult to save up for a larger down payment, but putting in the time to do that lowers your LTV ratio and makes the purchase less risky for you and your lender.

High debt-to-income ratios

Debt-to-income (DTI ratio) is the amount of monthly debt payments as a percentage of income. If you earn $5,000 a month and have $2,000 a month in loan payments, you’d have a 40% DTI ratio ($2,000 divided by $5,000).

Lenders like to see borrowers with low DTI ratios. It means their income has more cushion to make the monthly loan payments.

From a borrower’s perspective, DTI ratio is one measure of how tight your budget is going to be when you buy a house. A high DTI ratio gives you little room to make up for unexpected expenses or other financial setbacks. A low DTI ratio gives you more breathing room.

Investors cause risk in the housing market

According to CoreLogic, the share of residential properties being bought by investors has risen sharply in recent years.

That means more homes are being bought by people who plan to rent them out or sell them later rather than by the people who are going to be actually living in them.

A moderate amount of outside investment is good for the real estate market. However, when too much investment money floods into the market it can be bad for ordinary home buyers and owners for a few reasons:

  • The artificial demand created by investment dollars has helped drive real estate prices higher in recent years, pricing many would-be buyers out of the market.
  • Higher-priced investment properties may sit empty for longer, leaving neighborhoods with vacant buildings that may be prone to neglect or criminal use.
  • Investment money tends to come and go more quickly than owner-occupants. This can lead to sudden reversals in a neighborhood’s home prices. Sudden drops in values can leave the remaining home owners less flexibility to refinance their mortgages or sell their homes.

In short, too much investment money in the housing market makes prices both more expensive and less stable. One key factor home buyers should pay attention to is how many properties in a neighborhood are occupied.

Low-documentation mortgages

Though rules on this have tightened since the 2008 financial crisis, some mortgages require less detailed proof of income than others.

Having less documentation of income is riskier for lenders, so they charge higher interest rates for these loans. The fact that some buyers are willing to pay higher rates in exchange for providing less documentation in the application process is a warning sign.

Home owners with murky income sources may be less trustworthy and stable neighbors. Mortgage lenders get paid extra for taking on the risk of these buyers. Neighboring home owners do not get any benefit from it.

High prices

According to the S&P CoreLogic Case-Shiller U.S. National Home Price Index, the cost of the average residential property has risen by 46% in just three years.

The more you pay for something, the more you potentially have to lose. In the meantime, home buyers are forced to take on the burden of bigger mortgages that create more of a strain on their household budgets.

This represents a risk to home owners even if they can easily afford their mortgage payments. Living in an area where lots of your neighbors face foreclosure on their homes can affect you. It lowers property values, and may expose the neighborhood to more crime.

Rising default rates

Although mortgage default levels are not yet at historically high levels, they have been rising steadily over the past year. The S&P/Experian First Mortgage Default Index is up by more than 61% in just eight months.

Having more home owners default on their mortgages and get foreclosed is not just bad for the people who lose their homes. It brings down the entire neighborhood.

This is a trend to watch. Default rates are not yet alarmingly high, but they’re moving in the wrong direction. Also, these trends vary a lot from one region to another. Home shoppers should pay close attention to foreclosure activity in any neighborhood where they are considering buying a home.

Underneath all the complicated economic indexes, there are real-world trends causing risk in the housing market that affect ordinary home buyers. This is why recent news on the housing market deserves the attention of home owners and would-be buyers.

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Disclaimer: This guide to buying a house and getting a mortgage is for informational purposes only and is not intended as a substitute for professional advice.

Richard Barrington
Financial analyst for Credit Sesame, Richard Barrington earned his Chartered Financial Analyst designation and worked for over thirty years in the financial industry. He graduated from St. John Fisher College and joined Manning & Napier Advisors. He worked his way up to become head of marketing and client service, an owner of the firm and a member of its governing executive committee. He left the investment business in 2006 to become a financial analyst and commentator with a focus on the impact of the economy on personal finances. In that role he has appeared on Fox Business News and NPR, and has been quoted by the Wall Street Journal, the New York Times, USA Today, CNBC and many other publications.

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