What follows is a hypothetical account, but it illustrates a point of rational economic decision making in a world of economic distortion.
A middle-class, taxpaying, work-a-day family man decides in 2001 to buy a house for his wife and new child in a non-descript cookie-cutter neighborhood populated by other work-a-day families like his. He pays $100,000 for the house and he has put up $10,000 in equity that he has spent his working life to date saving. He is very happy in his new house and he takes great pride in keeping his treasured home clean and well-maintained.
A few years pass, and now it is 2004 and he has learned that a neighbor sold his home which has the exact same floor plan for $150,000. Now, our family man, seeing his child growing up, starts to think about saving for college, while putting his child in private school since the public schools in his neighborhood are not that good. Also, his wife complains that they have not had a vacation in years since they bought the house, and suggests they should take the family on a European holiday.
So our family man is stressed. He spends 1/3 of his paycheck on the mortgage, and after food, utilities, clothes, etc., there is not much left over. He talks to a co-worker about his financial situation, and the coworker suggests that he meet with a mortgage broker who can probably get him a new larger mortgage with similar payments, and he could pocket some money for these vital necessities that his family needs. So, our family man does meet with the mortgage broker and he learns that since his house is valued at $150,000, he can get a $140,000 loan with the same monthly payment for a three year period and he can cash out $40,000. Our family man signs the new mortgage.
A few years later, its 2008 and now our family man's mortgage has reset to where he needs to pay an additional $300 a month. He sees a house similar to his that has just sold for $125K.
If you were this family man, you would see that you invested $10,000 and saw a return of $40,000 over 7 years (300% over 7 years -- most venture capital guys would kill for this level of return). Now, you find that you can no longer make the payments without dipping into your personal savings, which are limited. You hear of a government program that will allow you to renegotiate the mortgage and you estimate you can save $300/ month (back to the mortgage expense in 2004).
Now, as economic rational man, you calculate how much you are saving on your mortgage per month ($300) against being upside down by $25K on your mortgage (over four years to pay back) and against the further potential decline in house value.
You see the follow options:
- 1. Continue with the current mortgage and make no changes
- 2. Take the government program and soldier on.
- 3. You can walk from the mortgage, and since you still have a good job, you can rent a similar sized house for the same money you are paying for your mortgage.
What do you do?