Opportunity Cost, Short Sales, Foreclosure and
Green Jello
As a follow-up to our recent article, When Banks Ruled the Earth, we thought it would be helpful to provide a brief context for clients that ever do face the decision to walk away from their home (and why they might want to consider it).
Core to the decision of whether or not to walk away from your primary residence or an investment property in a declining real estate market is the concept of opportunity cost. What is the opportunity cost of good credit versus cash in hand? If your home is worth less than you owe and you intend to occupy it for less than the time it will take for that value to be restored (and especially if you have other investment opportunities that may yield a better return during that recovery period), you have to ask yourself one simple question: what is worth more to me, good credit or my cash? If you have neither, it’s probably an easy question to answer, financially speaking in any case. If not, here are a few things to consider.
To begin, remember that walking away from one’s house does not necessarily equate to preserving cash in the same way that staying in one’s house does not guarantee preserving presumably good credit. Circumstances vary widely and outcomes are never guaranteed. In making and carrying out the decision, you should work closely with qualified real estate and tax advisers. Keeping that in mind, here are a few common situations we see:
I paid no money down, I’m upside down, and my finances are down. Sounds bad. But how bad is it? You owe more on your house than it’s worth but, even though you’re running out of money and assuming you haven’t spent a lot to upgrade or renovate your home, you haven’t lost much money on it either. If you’ve already missed one mortgage payment by 30 or more days, then your credit is already seriously damaged and will take several years to repair anyway, making the decision that much easier. If you are still making mortgage payments on-time and have good credit, look at your income, expenses, investment opportunities and real estate market conditions over a realistic time horizon. If you think you can hold on and expect the market to come back soon enough, holding onto your home and good credit might be a great option. If making that mortgage payment is too much of a financial burden and may result in damaging your credit down the line anyway (and assuming you can’t refinance for better terms today), you might be far better off short-selling your home as an alternative to foreclosure – thus retaining more of your future earnings.
I paid 20% or more down, my home value keeps depreciating and I’ve run into some financial trouble. This can be a challenging situation. Assuming you still have equity left in your home, if you walk away, you’re also walking away from the “cash” tied up in it. On the other hand, if you’ve come upon hard times and there’s no foreseeable end in sight for your finances or the real estate market, you might save more cash by walking away from the remaining equity in your home and lowering your cost of living until times get better.
I make a lot of money but I got into some unfortunate real estate investments and now I want to get out. This is where it gets very tricky. We’ll address this topic in more depth in future articles but it suffices to say that simply walking away from bad real estate investments can be difficult when you have a high income or net worth. Properly structuring investments to shelter personal assets from liability is one key to preventing entanglements down the road.
Finally, always keep in mind that your credit is only worth what you do with it. We talk to a lot of investors in our Green Jello state who tout their good credit but rarely, if ever, use it. For these, there is almost no opportunity cost if their credit is damaged. Others with whom we work, however, use their credit as a tool to improve their finances and lifestyle. These individuals value their credit highly and may be willing to give up equity or cash to preserve it.
The Payne Smoot Group is Utah’s premier real estate, wealth and property management firm. For more information on the Group’s holding companies, investment or employment opportunities, please contact (801) 717-7777 or info@paynesmoot.com.
