Upside Down Mortgage

Wiki Subprime Crisis

Question: housing prices and refinancing?

This is an excerpt from a Wiki article titled '2007 subprime mortgage financial crisis'

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While U.S. housing prices continued to increase during the 1996-2006 period, refinancing was available. However, once housing prices started to drop moderately in 2006-2007 in many parts of the U.S., refinancing became more difficult. Defaults and foreclosure activity increased dramatically......

Why does it become more difficult to refinance when housing prices go down? It seems that there is a reverse relation between housing price and burden of refinancing. Could anyone explain??

Answer: When taking out a mortgage for either a refinance or a new purchase, one of the most important points to a lender is the loan-to-value ratio (LTV). The higher the LTV, the higher the risk. As a property goes down in value, if the mortgage amount does not go down, then the LTV increases, thus increasing risk. Take this example...

If you purchased a home for $200,000 with an 80% LTV, this would mean your mortgage was for $160,000.

$200,000 X 80% = $160,000

The other 20% is your "down payment." This becomes known as your home's equity.

People refinance for a variety of reasons. Most people refinance to take money out of thier property. If you want to take out $40,000, you would need to refinance to a new mortgage for $200,000

$160,000 + $40,000 = $200,000

In a rising market, this is not a big deal. If the property went up in value by 25%, the property would now have a value of $250,000.

$200,000 + 25% = $250,000

To refinance to a new mortgage at 80% LTV, this would not be a problem and would give you your new mortgage for $200,000.

$250,000 x 80% = $200,000

After paying off your old mortgage for $160,000 you'd have your check for $40,000.

What happens if instead of going up 25%, your house goes down in value by 25%?

$200,000 - 25% = $150,000

Guess what? You now owe more money on your house than it's worth. If you are trying to refinance to take money out, it eould no longer be possible.

As I said earlier, people refinance for a number of reasons. Someone may want to reduce thier mortgage payment, so instead of trying to take cash out, they may want to put cash into the house. As long as the new mortgage has the right LTV ratio to match the lender's requirements, there would never be a problem.

In summary, it's all about LTV. If house prices go down, maintaining your LTV is harder. Most refinances happen because people are taking money out. Therefore, in a deflating market, it's more difficult to refinance.

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