Housing-bubble and real-estateSun, 30th Oct '05, 12:25 pm::

Anyone who cares whether or not there is a Housing Bubble in the US real-estate market right now should read The Fool. There's a big discussion over at Fark with many saying there is no bubble outside of a few places and many saying it is nation-wide.

A housing-bubble is when everyone is buying homes at prices higher than what they're really worth. Now obviously, the physical price of construction a house is pretty much the same anywhere in a large country like US except in remote locations like mountains because shipping and construction is more expensive there. So if a two-bedroom/one-bathroom house in middle of Kansas is $50,000 then it should be the same in New York, California, and Florida. Of course it is not, mostly because of the L-word - location, location, location. The location the house is built in, determines how expensive the house will be and if the location happens to be in a rich-neighborhood in Hamptons or Beverly Hills, even a moderate 6,000 sq. ft. house will be close to millions. The same house in rural Indiana would be way below, and with probably ten times more acreage.

I bought my house in June for around $150k on a 30-year fixed mortgage. This means that for the next 30-years, I will pay a fixed monthly amount to the bank and at the end of 30-years, I will own this house fully and won't have to pay anything to live here, other than taxes etc. Now suppose I pay $1,000 a month in mortgage in year 2005. That means even in year 2015 when my salary will be hopefully much higher because of inflation and job promotion, I will still be paying a fixed $1,000 per month. Due to the fixed nature of monthly mortgage payment and rising salary, paying monthly mortgage should become easier and easier every year. This happens when you get a 30-year fixed mortgage. Of course, I could still sell the house anytime and move to a different neighborhood and choose to rent or own property again. But if nothing changes, I pay a fixed mortgage a month and gradually build equity.

Equity is my share of the house mortgage that I've paid up, added to the increase in house value since I bought it. Suppose I bought a house 10 years ago for $100,000 and have paid $40,000 towards the mortgage principal. Now suppose I can sell the same house today for $250,000. Then my equity is $40,000 + ($250,000 - $100,000) = $190,000.

Notice how I said "mortgage principal" and not "mortgage." There's a difference. These fixed x-year loan mortgages work on an amortization basis. Amortization is when you borrow some money (called principal) and instead of just paying interest each month/year, you also pay part of the original principal. So suppose you borrow $100,000 from a bank to buy a house at fixed 6% annual interest, then each month, you have to pay $100,000 x 6% / 12 = $500 interest. This is just the interest. If you pay $600 each month, then the $100 above your $500 interest goes towards paying off your principal. So if after the first month, you paid $600, then $500 goes towards interest on $100,000, while the $100 goes towards reducing $100,000 to $99,900. Now in the second month, you only have to pay interest on the principal of $99,900. This means if you still pay $600, your interest will be LESS than $500 and your payment towards the principal will be MORE than $100. Each month you will be paying less interest and more principal. Your last payment will go 100% towards the principal and no more interest. Then you will have paid off the loan.

However, if each month you only pay $500, that is your exact interest, then you still owe the bank exactly $100,000 at the end of every month, year, or decade. And when your loan term ends, you have to somehow find $100,000 to return to the bank! And THAT is the mistake everyone is making right now, buying expensive houses on short-term interest-only loans.

Interest-only loans are great if you KNOW what the hell you're doing with every last penny you have. If you are a common person who is better at welding cast-iron or programming in PHP, you most probably aren't too good with making the most out of your interest-only loan. However, the problem is that when you were thinking of buying a house and realized that every house you want is out of your price-range, your mortgage-lender/bank suggested that you go with interest-only loans. At that time, you wanted a two-bedroom/one-bathroom house in a nice neighborhood but could only afford $1200 a month. Since every house was $200,000 or above, your monthly mortgage on 30-year fixed would be over $2,000. However, if you went with interest-only loans, then you could in fact pay just the interest on $200,000 and live in your dream house! The mortgage broker said "Don't worry! After 3/5/10 years when you have to pay the full principal of $200,000 in ONE day, you can just sell this house for way over $200,000 and buy another one that's even bigger with the extra money you make. Or you can just refinance when the interest-rate falls lower and get an even better deal."

Except that, interest rates right now are about the lowest they're gonna get unless US economy changes drastically. And that you will only be able to pay off the interest-only loan if in fact your house will be worth more than $200,000 after 3/5/10 years. So what happens if three years after you bought the house on a variable interest-only ARM 3/1 loan, the real-estate market crashes and the interest rates shoot up? You get totally screwed. And that is what everyone is afraid of right now.

If there is in fact a housing bubble, then at some point in the near future, it will pop. When the housing bubble pops, nobody will be able to sell a house for a profit. Normally, that would be fine because if you don't make a profit, you don't get screwed - you just don't get the extra money you were hoping to get. However, if you were RELYING on that profit to not be screwed, because you had an interest-only loan, then well, when there's no profit, you are royally screwed. Bankruptcy and foreclosures will abound. And that's what everyone is afraid of. The realtors selling houses will try to maintain face, saying there is no bubble. They say it is localized to only specific places and not nation-wide.

I honestly hope they are right. Because if they're not, many people are going to be, literally, homeless.

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