Are Mortgage Balloon Loans Safe if the Bubble Bursts?
May 5, 2003

Note: January 28, 2010. I decided to keep this article as it was originally written, it has some historical value, rather than revise it. 

"What happens if the housing bubble bursts? Will I lose my house if I owe more on it than it is worth? If I take out an ARM or balloon loan, will I be able to refinance them when they come due?"

If you continue to pay your mortgage on time, you don’t lose your home when its value drops below the mortgage balance. While your ability to refinance may be compromised, you don’t need to refinance an adjustable rate mortgage (ARM). Balloon mortgages could be trouble, though.

A bubble is a marked price increase buoyed by expectations that prices will continue to rise. In a bubble, underlying value becomes irrelevant, you buy because you believe you will be able to resell at a profit. Once that expectation comes into serious question, the bubble bursts, as it did with internet stocks in 2000.

Markets in common stock are vulnerable to bubbles because it is easy and cheap to buy and sell. Sales commissions are small and the cost of holding stock is negligible.

The house market, in contrast, is much less vulnerable to bubbles because the cost of buying in order to resell is very high. A "round trip" in a home (purchase and sale) costs 10% of the property value or more in sales commissions alone. To this must be added the cost of holding the home between the purchase and sale dates, including financing costs, property taxes, and insurance. Carrying costs are especially steep if you aren’t living in the house.

This doesn’t mean that the home market is completely immune to expectations of rising prices. If this belief is widespread, some consumers will purchase earlier than they would have otherwise, some will opt for more expensive houses, and some of those trading up will elect to rent out their existing houses rather than sell them. These and other such actions can create a mini-bubble in the home market, which can burst like any other bubble.

But since the bubble doesn’t get very big, the fall-out won’t be severe. Prices may decline modestly for a few years, before starting to rise again. The fundamentals underpinning this market are so strong that it would take a major depression, such as the one we had in the 1930s, to cause a prolonged and severe decline in home prices. And that is not in the cards.

This may be scant consolation to those who purchase houses with little down, who find themselves owing more than their house is worth. However, your lender can’t take your house away from you when this happens, nor would he want to.

In situations where the mortgage balance exceeds home value, lenders worry about owners who "send they keys to the lender". Such owners shift the loss to the lender, sacrificing their house and their credit rating. Most owners, however, elect to gut it out until the market turns in their favor.

When equity in the home has disappeared, the possibility of a cost-reducing refinancing usually disappears with it. However, rate adjustments on ARMs are not refinancings. The ARM rate adjustment occurs on the existing instrument, not a new one, and it is affected only by what happens to interest rates. It is not affected in any way by what happens to home value.

While balloon loans are refinanced at the end of their term, generally 5 or 7 years, the lender commits to refinance at that time and can’t beg off because the property value has declined. The refinance commitment, however, is hedged in several other respects that could cause a problem for the borrower who has no equity in his house.

First, the lender need not refinance if the borrower has been late on a single payment in the preceding year. That is scary. Second, the refinance commitment is at the lender’s current rate. The borrower with no equity will be obliged to accept that rate, whatever it may be, because he has no place else to go. Third, if that rate is 5% or more above the old rate, the lender need not refinance.

The likelihood of rates being 5% higher while property values are lower is very low. Generally, property values decline in a weak economy and interest rates rise in a strong economy. Nonetheless, it could happen.

If I were buying a house with a small down payment in a neighborhood that had been rapidly appreciating, I would avoid financing it with a balloon loan. But an ARM is OK.
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