Nearly a decade has passed since the housing bubble burst and over the last few years, the market has been on a steady upward climb. According to RealtyTrac, foreclosure rates declined by 7 percent between November 2014 and November 2015.
While that’s a positive indicator of the housing market’s recovery, there are still nearly a million homeowners in the U.S. who are either in default on their mortgage or already in the foreclosure process. That figure includes a number of home-buyers who purchased their homes just prior to the housing collapse.
So what went wrong? Aside from problematic lending practices on the part of the banks, many homeowners got in over their heads with their mortgages because of poor planning. For buyers who are approaching the market now, there are plenty of lessons to be learned. Here’s a look at the biggest mistakes home-buyers made in the midst of the housing crisis.
Mistake #1: Skipping out on a down payment
Putting 20 percent down on a home has long been the industry standard. From a buyer’s perspective, offering up a big down payment serves two purposes. First, it allows you to avoid paying private mortgage insurance or PMI on a conventional loan. This is an added cost that the lender tacks on to your mortgage when your loan to value ratio exceeds 80 percent.
The purpose of PMI is primarily to protect the lender. If you default on the mortgage and the bank forecloses, the private mortgage insurance is used to cover the associated costs. The amount of PMI you’ll pay depends on the size of your mortgage but it can easily run $100 or more each month.
The other benefit of putting at least 20 percent down on a home is that it allows you to build up equity in the property right from the start. Prior to the housing market collapse, lenders were allowing buyers to get a mortgage with as little as 10 or even 5 percent down. In some cases, lenders were even offering zero down financing based on the theory that home prices would keep on rising.
When the market collapsed, buyers who had put down less than 20 percent or nothing at all saw their property value go spiraling into a black hole. The result is that many of them who were struggling to keep up with their mortgage payments simply chose to walk away from their homes.
Mistake #2: Having unrealistic ideas about home affordability
One of the biggest contributors to the housing collapse was the fact that lenders were granting borrowers loans that they couldn’t really afford. It became common practice for banks to green light mortgage applications without verifying whether the buyer actually had enough income or assets to sustain the payments.
While there’s no question about how damaging that was to the market as a whole, borrowers share part of the blame. At that time, owning a home seemed like a great investment as property values continued to shoot up so buyers were jumping on the opportunity to get a loan without taking the time to see how a mortgage would fit into their budget.
That’s still a trap it’s possible to fall into today, even with tighter regulations on lending. If the bank pre-approves you for a specific loan amount, you may assume that you can afford to pay that much for a mortgage but that can set you up for trouble. Getting pre-approved can give you a guideline for how much you can spend on a mortgage but it doesn’t replace the need to add up the specific costs of home ownership, both in the short and long-term.
Mistake #3: Choosing high-risk financing
One of the biggest errors home-buyers made leading up to the bubble was taking on risky mortgages with the expectation that they could refinance to a conventional loan later on. Lenders were pushing interest-only and adjustable rate mortgages to buyers who only saw the lower payments and weren’t banking on the bottom falling out of the market.
When the housing crisis hit, it set off a chain reaction in the larger financial sector that resulted in many homeowners losing their jobs. Once their interest-only loans or ARMs reached the reset period, they found themselves facing much higher mortgage payments. Without a job and a steady source of income, they weren’t able to refinance their way out of those loans nor could they continue making the payments.
These days, interest-only loans and ARMs are making something of a comeback but prospective buyers should approach them with extreme caution. Even though the market seems to be holding steady, a conventional loan remains the safer bet, especially while interest rates remain low.
Mistake #4: Forgetting about the ongoing costs of home ownership
With lenders willing to hand out bigger mortgages, many buyers succumbed to the temptation to take on a bigger home. The only problem is they didn’t account for the added cost of maintaining a more expensive home.
Buyers who are heading into the market now can avoid this same mistake by sticking with a home that fits their budget and factoring in all the costs associated with owning a home. That includes not only the principal but also the interest, homeowners’ insurance and property taxes. If you’re living in a private community, you’d also need to add in the cost of homeowners’ association fees.
Once you’ve got an accurate estimate of how all these extras add up you can compare it to your income to see just how much mortgage you can afford to take on. A good rule of thumb to follow is to limit your total debt payments, including housing, to 36 percent or less of your income each month. If you bring in $4,000 a month, for example, you could afford to spend $1,440 on housing costs and any other debt payments you have, such as student loans. Keeping that ratio in mind can keep you from overextending yourself where home ownership is concerned.
Mistake #5: Not having a backup plan for emergencies
An emergency savings cushion is something every homeowner should have. That’s money you can tap into if you need to replace the hot water heater or you lose your job and need to cover your mortgage payments until you’re working again. Unfortunately, buyers were snatching up homes during the housing bubble without giving any thought to whether a rainy day might be headed their way.
According to the Federal Reserve, the national savings rate in January 2006 was an unimpressive 3.8 percent. When the financial dominoes started falling, many homeowners found themselves having to choose between making the mortgage payment and covering the necessities, like groceries and keeping the lights on. Having 3 to 6 months’ worth of expenses set aside could have made the post-housing collapse ride a little smoother for some homeowners.
Despite seeing how homeowners have struggled since the housing crisis, Americans still aren’t as serious about saving as they should be. Roughly one-third of adults in the U.S. have no cash reserves to fall back on according to a June 2015 Bankrate survey. If you’re planning to wade into the housing market any time soon, having some cash set aside can be a life-saver. Check out our step-by-step guide to building an emergency fund if you’re not sure how to get started.
Mistake #6: Not managing other debts
Buying a home when you’re already in debt puts even more pressure on your monthly cash flow and that’s something buyers during the housing crisis found out the hard way. Research from TransUnion shows that between 2007 and 2011, homeowners were more likely to pay their credit cards or car payments first before paying their mortgage.
While that trend has since been reversed, it illustrates how problematic taking on a mortgage can be when your financial resources are already spread thin. In the wake of the housing collapse, homeowners who had no emergency savings turned to their credit cards to cover the gap. To keep their credit lines open, they had to keep up with the payments. To get back and forth to work or look for a job, they needed to make sure their car payments were current. Meanwhile, their mortgage got lost in the shuffle.
Paying down debts before making the move to home ownership may mean delaying your purchase but your budget will thank you in the long run. If another financial crisis were to come along, the question of whether to pay your credit cards or your mortgage isn’t one you want to have to deal with.
The Bottom Line
The passage of time has softened the blow the housing market crisis has had on the economy but some homeowners are still reeling from the effects. Learning as much as possible from what they did wrong can put current and future buyers in a position to avoid having history repeat itself.
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