In a healthy real estate market, people only take on as much debt as they can afford, and they work to pay it off as quickly as possible. Debt is something to be retired not endlessly serviced.
If you look at the equity curve of real estate, you see that equity is built in 3 major ways:
1. Speculation.
2. Inflation.
3. Debt Retirement.
A truth that everyone is becoming painfully aware of is that speculative equity is not stable. Prices once detached from fundamentals will return to them at some point. The return to fundamentals is either accomplished through actual price declines or a period where prices increase at a rate less than inflation. It is usually the former. Speculative equity cannot be counted on, and it is only captured through careful analysis or blind luck. It is usually the latter.
Inflation equity is really not equity at all. If your house doubles in value in 20 years, but the value of the currency has cut in half, you really haven't gained anything. On paper you have a gain, but the money you get out has no more buying power than the money you put in, so you really haven't benefitted as much as you think you have. Inflation equity will preserve your wealth, but it will not add to it.
The real way to make money through long-term ownership of real estate is through obtaining financing equity. You get this by paying off your loan. This method of building wealth, the only one that really works, has been much maligned over the last decade as fantasies of easy money through boundless appreciation gripped the market.
The last time we had a healthy, fairly valued market in California was from 1995-1999. During this period, people did not believe in endless appreciation because prices had been declining since 1991. Buyers realized the only way to make money in real estate was to borrow a small amount and pay it off or pay such a small amount that you could rent the place for positive cashflow. Once prices start going up, people see that they can profit from appreciation, and the slow, steady method of building wealth through retiring debt seems rather quaint and old-fashioned.
Once prices start really going up, paying down mortgage debt is an unnecessary financial burden. Why bother paying an extra $500 a month toward your housing debt when the house is going up in value about $5,000 a month? Why not just use interest-only financing and spend that $500? Well, that is such a good idea, the next step is obvious: why not utilize a loan where you don't even pay the interest and free up that payment money for consumer spending. The Option ARM is born.
But why be satisfied with only falling behind $500 a month on your mortgage when house values are going up $5,000 a month? Why not borrow more? Why not go withdraw the equity in huge lump sums? After all, it is accumulating far faster than it can be spent. If you refinance or open HELOCs periodically, you can extract this free money as soon as it becomes available. Why not?
Do you see how speculative equity is a slow seducer? The foolish and irrational seems completely logical when you look at the changing circumstances.
When a Ponzi Scheme is built on debt, like it was during the Great Housing Bubble, each person in the chain must assume a larger debt than the person who came before them. Since nobody is paying down debt, and since most people are furiously adding to it, the amount of debt buyers needed to take on in order to pay off the debts of the seller becomes very large. There is a point where the debt becomes too large for people to service, and they default on their payments. Once banks stop getting paid back, they stop making loans: a credit crunch.
The challenge for lenders in the wake of a crashing Ponzi Scheme is to rediscover the debt-to-income levels people can support for residential real estate. Historically this number has been around 28%. The challenge for the market is to endure the crash back to pricing levels consistent with stable borrowing levels. We are in that process right now.
During the price decline, market psychology will also change. People will slowly recognize that the personal financing methods they believed were stable during the bubble (interest-only and negative amortization loans at high DTIs) are not stable and should not be used. As long as market participants believe in the fantasy of speculative equity, they will utilize whatever means of financing is available to them to acquire as much real estate as possible. It is the knife-catcher mentality. The slow grind of declining prices will pulverize this faulty thinking over time, but in the interim, people will continue to overpay for real estate to the degree that they can.
Eventually, it will become widely recognized that borrowing a small amount and paying down a mortgage is the only real method of accumulating wealth in real estate. Of course, when this happens, the market is at the bottom, and the whole cycle begins all over again...
Lawrence Roberts is the author of The Great Housing Bubble: Why Did House Prices Fall?
Learn more and get FREE eBooks at: http://www.thegreathousingbubble.com/.
Read the author's daily dispatches at The Irvine Housing Blog: http://www.irvinehousingblog.com/.
housing, real estate, buying real estate, housing bubble, real estate bubble, house for sale
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