No skin in the game

Rather than purchase a “starter home” (which I define as a modest first home one seeks to trade-up for as soon as one has moved in) my wife and I rented until we could afford a home we actually loved.  However, rather than purchasing the nicest home we could afford, we chose to purchase the most modest home that we could be happy with.  Though our home is small it has a terrific location and lovely interior.  It fit our family perfectly until we had a second child.

For a while after the birth of that second child we considered trading-up and buying a bigger home.  However we loved our neighborhood so our search for a new home was limited to three-bedroom homes within an area less than one square mile.  Even though my income was more than double what it had been when we purchased our home, we couldn’t find anything I felt I could comfortably afford.

There was only one home we ever seriously considered purchasing.  In 2004, I looked at a townhouse two blocks away with an asking price of $899,000.  Buying it would have doubled, and possibly tripled, our mortgage.  To afford it I would have gone from a mortgage with nine years remaining to a mortgage that I might not have paid off until I was seventy-two years old.  Further, I felt comfortable with the mortgage I had–believing that even in a bad year I could afford it and that even with a downturn in housing values I would still have substantial equity in the home.  I was not convinced that I could afford the mortgage needed for the new home if I encountered one of the myriad setbacks to which life is prone.  After doing the math, I decided not to make an offer.

The home was ultimately purchased for $792,000.  The buyer later needed my services to defend a real estate fraud claim and I later needed to obtain a judgment against him to get him to pay my fee.  He was unable to afford the mortgage and, as I read in today’s Charleston Post and Courier,  just recently sold the home for $628,000.  I would suspect some lender is owed in the neighborhood of $200,000, with no expectation of recovering these funds.  Multiply this story by a million (or ten million) and the roots of the current economic downturn become clear.

In the 2005-08 time period, I was amazed at the number of upper-middle class clients who had a primary residence in which they had little or no equity stake, purchased on loan terms they had little expectation of actually being able to meet.  It is my perception that my parents’ generation of upper-middle class professionals treated their residence as their most important investment.  They were extremely cautious about doing anything that would jeopardize that investment, as it would mean uprooting their family and losing a substantial portion of their net worth.  In contrast, these clients had purchased a home in which numerous foreseeable events–short-term job loss or income reduction; sharp rise in interest rates; temporary lull in the rise in housing prices; divorce–could cause them to risk foreclosure.  All of these clients could have purchased nice but more modest homes in which their foreclosure risk would be greatly reduced; yet they chose to purchase showcase homes that were subject to being lost unless everything went right.  Some of my most agonizing and expensive divorces during that time period involved liquidating such homes when something went wrong.

In hindsight, I understand why I was unable to find a slightly larger home in my neighborhood at a price I felt comfortable paying: I was competing against peer who were willing to risk eviction from their family home in a desire to purchase the nicest home that some financial institution would lend them the money for.  Jockeying for homes against folks who had much lower regard for risk meant I would always be outbid: when you risk other people’s money, with no skin in the game, you can pay whatever amount these other people are willing to lend you.

Americans are suffering the consequences of a casino economy in which irresponsible borrowers could outbid responsible borrowers, inflating the price of housing assets throughout the United States.  I still encounter clients who refuse to liquidate homes they cannot afford because they cannot find buyers willing to purchase the house for what it was “worth” in 2007–these clients not understanding that those housing “values” were created by unsustainable lending practices.  Ironically, had I been able to purchase the townhouse I considered in 2004 for $628,000 I might have done so.  Instead my daughters have shared a bedroom for the past eight years.  However, my mortgage is current and should be satisfied in a little over three years.

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