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Sunk Costs and Underwater Mortgages

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:

  1. 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?
  2. 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.

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  1. I often disagree with the decision to sell a house because a person is underwater. In this new age people incorrectly assument that a House=Investment. This is true for a few select groups who make a living by investing in the housing market. However, for the rest of us the House=Home. It is a place to live, to build memories. It provides warmth from the cold and should give a family a sense of security.

    The reason to sell is because the family wants to relocate, upgrade, or downgrade. But the reason should not be because I don’t like the market value of my house?

    Can a family really afford to rent of buy another house with $50,000 in debt to another mortgage company? This post also does not mention any potential backlash on the credit report.

  2. Mike,

    I agree that you can’t consider your original cost when deciding to sell a home, but having to come up with $50K in cash to sell is a pretty big barrier to overcome! I wonder if mortgage lenders would allow people to transfer the mortgage to an unsecured loan, and at what rate?

    >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.

    I can think of one financial reason to keep the home- inflation. Say that you can just barely afford to continue paying the mortgage possibly only paying the interest and that the only effect on the price is inflation. If inflation is 3.5%/year (the long term average) after 6.5 years you should be able to sell the house for the $250,000. It isn’t that the house really appreciated- it’s that the money you owe depreciated!

    -Rick Francis

  3. Hi Ben.

    I’m not advocating selling because the homeowner is underwater. All I’m trying to point out is that the original purchase price of the home doesn’t have much to do with whether you should keep it or not.

    And you’re right that a home has a value other than a financial one. Sometimes a decision may make financial sense, but still not be the right decision.

  4. “I wonder if mortgage lenders would allow people to transfer the mortgage to an unsecured loan, and at what rate?”

    Agreed. This is the primary reason why I wrote that it may make sense to sell the home, rather than does make sense to sell the home. Availability of cash and/or reasonable-interest-rate credit is certainly an important factor.

  5. Mike,
    Thanks for this article.
    Someone I know owes money on their house, but they don’t want to tell it until they can at least break even. I’ve tried to explain that they are in the exact same place financially if they sell it now or later, but I haven’t exactly been able to convince them. Perhaps giving them options #1 and #2 will help make things clear.

  6. Another reason — afraid it is a wooly one! — is that for most people the reason buying a home makes sense is it provides an inflation-protected savings plan.

    For such people, it is a discipline to pay the mortgage, like the dollar cost averaging we both suggest is a good approach to the stock market.

    Continuing to hold and keep paying until better times makes sense as a ‘coping mantra’ to keep up this saving scheme.

    The reality is when the market recovers they won’t sell. Or they will, but to buy a more expensive home!

    Just like with stocks, in other words. 🙂

  7. I realized after I had posted the comment that your point was that sunk cost doesn’t matter, that the choice to sell should be independent of the original cost.
    But the answer didn’t seem to jump out at me until I had read the article a few times.

    I know there is a physiological term for not being able to ignore the sunken costs. Maybe it’s anchoring? I can’t remember.

  8. To be honest, if I could sell the house and pay off my mortgages, even if I took a sizable loss, I would do it tomorrow. Even though it would be nice to break even on the purchase, more than anything else, I just want out of mortgaged home “ownership.”

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