Sunk Costs and Underwater Mortgages
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Two wrongs don’t make a right. Similarly, two poor investment decisions don’t add up to one good investment decision.
In the last few weeks, I’ve come across two articles discussing scenarios in which a homeowner was “underwater” on his/her mortgage. In each case, it was indicated that selling the home is a poor choice because the homeowner would have to take a loss on the transaction.
For instance, my friend Matt wrote the following in a guest post for Five Cent Nickel:
“Though getting out from under the mortgages is tempting, I decided against it for mathematical reasons. If we were to sell now, we would not only lose money on the transaction, but we’d have to pay cash to our lender. If I could wind up even money, I would sell tomorrow.”
The thing is, emotional and tax consequences aside, the price paid for the house is now irrelevant. It’s a textbook example of a sunk cost. All that matters is information that affects your situation going forward.
Imagine the two following scenarios:
- You don’t own a home, and you have $50,000 in consumer debt with a 7% interest rate. Would you take out a $200,000, 7% mortgage to buy a home with no money down?
- You do own a home, currently valued at $200,000. Your outstanding mortgage is $250,000, with a 7% interest rate. Should you sell your home?
Most people would agree that the person in situation #1 should probably not buy the home. But many people would be reluctant to sell the home in situation #2.
To phrase it differently: If you didn’t own a home, would you buy the house you currently own for its current market value? If not, it may make sense to sell it.
Where will home prices go next?
In much the same way that stock investors often seek to hold their losing stocks until they’re “back to even,” homeowners interested in selling often seek to hold their home until it’s back to the price for which they bought it. For example, Cathy Curtis wrote the following in a post for Morningstar Advisor:
“Until the real estate market starts to recover for high-priced homes, selling is not a solution.”
But unless you have some reason to expect real estate prices in the market in question to come roaring back, there’s no particular (financial) reason to continue carrying debt to own the home.
If buying was a mistake, opting not to sell is not (usually) a correction of the mistake.
Like Cliffs Notes…for Investing
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