There is no doubt that we are heading into a marketplace where property values are going to either flatten or decline. In many areas, this is already happening. There is a good chance that home values are going to drop in future months. What concerns me here is what part past mortgage choices might play in a market with declining home values.

Let me explain why I am concerned.

It is no secret that homes in silicon valley have reached all time highs in the past few years. At the same time, the real earning power of the average silicon valley resident has not increased a great deal. Add to that, we have seen a record number of people buying property in the belief that the market would continue to be strong and robust.

Enter, the 100% interest only mortgage.

For many, the only way that they could afford to buy a home was to get a 100% loan. In addition, the only way to afford those payments was to get a loan that was interest only for the first 5 or 10 years. Let us be clear on what "interest only" means. If you get a interest only loan, that means that all of your payment goes towards interest - you do not pay down what you owe at all. 

Example of a 30 year Fixed interest only for 5 years loan.

 So you purchase a home for $750,000 - a very realistic number for an average home in Santa Clara County say in 2001 or 2002. Lets look at the numbers

To get a handle on why someone would choose this type of loan, lets look at what a 30 year loan would look like, without the interest only feature:

However, what happens when that interest only period comes to an end? Lets say that we are 4 years and 11 months into our loan. Our loan is about to exit the interest only period and now our loan is going to be normally amortized over the remaining 25 years of our loan. Lets take a look at that new mortgage payment:

So after that interest only period is completed, the monthly payment is going to increase by $1082.26. If the owners income has not increased enough to cover this amount, what do they do?

So what do they do?

So imagine this homeowner. They decided on this type of financing to save some money on their monthly payment. Maybe they figured that they would sell their home before the 5 year interest only period ended, only to find they could not afford to change homes. Perhaps they assumed that their income would increase enough  to allow for such an increase in the monthly mortgage payment.

Now, what if we do see a market where home values drop. The average home price in Santa Clara County last month was just over $900,000.00. Back in 2002 (4 years ago) the average home price was under our example above at about $650,000.00.   Could home prices drop enough by next year to create a situation where those folks owe more than the home is worth?  What about those who bought in 2005 and are seeing the value of their home dip below what they owe? While folks who bought before 2005 might be alright, those who bought in 2005 or later are potentially in a dangerous place. (Check the numbers in Santa Clara County in my previous article ).

Lets run the same numbers above for a representative sale in 2005 for a $950,000 home.

100% INTEREST ONLY FOR 5 YEARS LOAN

NEW PAYMENT AFTER INTEREST ONLY PERIOD

That is a monthly payment increase of  $1,370.86. Imagine you bought your home in San Jose last year and you are now faced with a market where you owe more than the home is worth. What would you do? You have 4 years left till your payment changes to the higher amount, but your faith in the market might just be shaken and you might be thinking the market will be worse rather than better in 3 or 4 years. Since selling your home would cost you money, you really have no choice but to wait it out or try to get at least what it would cost you to sell before the market drops further.

Since many will be unable to afford the new increased mortgage payment at the end of the interest only period, it is likely we will see an increase in the number of homes being offered for sale. These sellers will want to cash out before their mortgage increases. The market already has a large number of homes in inventory, increasing that inventory, particularly filling it with motivated sellers, will only serve to bring down home prices further.

Then you have to wonder where these sellers will go. They still need a place to live. Does this result in them buying a home that is smaller? Do they rent? If the market is in decline, it is more likely that they will not buy at all. Will this increased demand for rental properties increase rental rates?

When owners who have these kinds of loans really start looking at the numbers, particularly those that bought in the last two or three years, I can see a strong motivation for them to try and sell their home before values drop below what they paid - and still owe - on their homes. For some of these folks, they would already be in a position where they would LOSE money on their home if they attempted to sell it today. In 2005 at this time, folks were paying an average of $950,000.00 for a home in Santa Clara County. Here we are a year later and that same home is pretty much worth the same amount, if not a little less - in some areas, unquestionably less. Those home owners that used one of these 100% interest only loans already find themselves in a position where they likely owe more than the home is worh.

What will happen in the months to come if property values drop further? These folks won't be able to get any new financing.  If they sell their home they will end up OWING money. For some, these past mortgage choices could be a recipe for disaster.

Then consider that some of these folks that got interest only loans did not get 100% financing - but sometimes OVER that amount! Some loans floating around out there were for 103% or more of the value of the home. These types of loans are still being given today. In all honesty, I did not see many of these, so I would suspect they don't make up a huge amount of these types of loans.

So what is the big picture?

If we imagine the worst case scenario, we end up seeing declining home prices. With that decline, owners who bought their home with these kinds of loans in the last 3 years or so could find themselves in a very difficult postion. Some owners whose homes are still worth at least what they paid may see this as the time to get out while they can. The rush to sell would, again, work to bring down home prices.

They won't be able to sell their home for what they owe. They won't be able to afford the new monthly payment after the interest only period ends. Could this lead to an increase in foreclosures and bankruptcy? According to recent article in RealtyTrac , the foreclosure filings are up 39% year to date. You have to think that past financing choices and the poorly performing market are playing a part in this trend.

At the very least I would suspect we can count on an increase in the number of homes put up for sale. That factor alone will further drive down prices. 

From historical sales data, the folks who bought 3 or more years ago are not likely to be negatively effected here. At least not to the point that they owe more than their home is worth.

For others, that bought their home in the period from 2004 and on, the market in the coming year might be a scary place. 

Finally, for those that bought using more conventional means, this may still mean that their equity is negatively effected, but at least they are not staring down at a huge mortgage payment increase coming when their property may not be worth what they owe. In short, they are far less likely to be put into a situation that could push them over the edge into foreclosure, forced selling or bankruptcy. 

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