Financial Recovery Articles
Don’t Let Clients Be Run Over by Real Estate
Lawyers Weekly
September 2005
By Brian Pritchard, CA•CIRP
Housing stays on fast track as prices soar. (The Globe & Mail August 31, 2005)
Sales of existing homes should set a record this year, real estate agents say (CP, August 30, 2005)
For lawyers involved in the consumer real estate sector, these headlines are reason for celebration.
But, there’s also a downside to the real estate juggernaut. More homeowners are becoming house-rich, but cash-destitute. As a professional whom your clients hold in high regard, you may be able to provide those contemplating a home purchase with some wise counsel -- so they don’t get run over by real estate.
As rising house prices contribute to people feeling wealthier, this “real estate wealth effect” is also supporting a plethora of consumer spending – and debt. During the first quarter of 2005, the annualized growth in consumer credit was 12.7%. As personal disposable income rose by only 1.2% over the same period, the debt-to-income ratio climbed for a sixteenth consecutive quarter – to 116.5%.*
Purchasing a home has become almost irresistible. Consumers can find variable mortgage rates for less than 4% and even some five-year rates at less than 5%. ** In addition, some lenders require virtually no down payment.
The lure of low interest mortgages and no-money down offers for household hard goods is motivating people to buy – even when they have to stretch their budgets to do so. Consider Jay and Pat’s situation. This couple purchased a house last year for $275,000, paying $20,000 down and taking a one-year mortgage. They paid more than they had originally intended, but housing prices in their area were soaring and they wanted to get into the market while they felt they still could. They’ve been using credit cards to pay for many expenses, and carry balances on their cards, which are rising each month. When they purchased their home, they also purchased furniture and appliances through a “no money down, don’t pay until next year” program. “Next year” has now arrived, their mortgage is up for renewal – potentially at a higher rate -- and they can’t make all of their monthly payments.
Jay and Pat’s situation is not uncommon. In fact, others facing similar financial problems have contributed to a 5% increase in consumer insolvencies from the second quarter of 2004 to the same period in 2005.*
The good news is that the real estate wealth effect also offers folks like Jay and Pat more options to get back on track.
Obviously, the best situation is one in which people don’t get caught in a cash crunch to begin with. When you’re in a position to advise clients, good guidelines to suggest are those used by lenders to determine the maximum mortgage that a buyer can afford.
- Monthly housing costs (mortgage payments, condominium fees, taxes, insurance, utilities and heating) should be no more than 32% of gross monthly household income
- Monthly debt load (housing costs, auto payments, credit card payments, loans,
child support and alimony payments) should be no more than 40% of gross monthly income ***
It’s also a good idea to advise clients to project their household income and monthly expenses for the period when the mortgage would come due. This will help them determine what their expenses are likely to be – and whether they will be able to afford them.
If, however, your clients have not only a home, but also a cash crisis, there are some options to free them from the wreckage. Historically, many consumers would declare bankruptcy in order to eliminate overwhelming debt. However, debtors who declare bankruptcy that have equity in a home may be required to surrender the house or pay a trustee the value of the equity to distribute to creditors.
A better outcome can be achieved by filing a consumer proposal that leverages the equity in the home to retain the property and eradicate debt over a period of time. Consumer proposals are available to those who owe up to $75,000 (exclusive of mortgages on a personal residence) and can no longer pay their debts as they become due or who cannot liquidate assets to pay debts. Generally, consumer proposals involve offering unsecured creditors an arrangement of payments (lump sum, monthly and/or balloon) over a period of up to five years.
Using Jay and Pat as an example, let’s say they have $25,000 of equity in their home. If they opted for bankruptcy, they could lose their home and creditors would receive that $25,000 of equity. Instead, Jay and Pat could make a formal proposal to creditors that might take one of the following forms.
- If their credit rating allows for it, they might renew their mortgage for $10,000 more and use that equity to pay creditors.
- They could offer to pay creditors slightly more than the amount of the equity in the home – perhaps $28,000 -- payable over a period of five years. Creditors are likely to accept this proposal since they would receive more than they would in a bankruptcy – and Pat and Jay benefit because they would have more affordable monthly payments and would pay no interest on the debt.
- If Jay and Pat can’t afford to make the monthly payments necessary to reach $28,000 within five years, they could make nominal monthly payments based on what they can afford, and offer a balloon payment that would be due within five years. At that time, the equity in their home would likely have increased and they would be able to refinance their mortgage, using the equity to make the balloon payment.
Consumer proposals can offer a solution for people in a variety of financial situations – for folks like Jay and Pat who simply hope to retain their home – and for those who wish to refinance an existing mortgage or to obtain a second mortgage. When a debtor completes the terms of a proposal, this individual will be in a stronger financial position – and thankful for your advice that got him there. So go ahead, help your clients jump aboard the real estate juggernaut – just be sure to advise them how to avoid getting run over by that real estate …
Brian Pritchard, CA•CIRP, trustee in bankruptcy, is a senior vice president of BDO Dunwoody Limited (www.debtworries.ca), which has been helping individuals and businesses solve their debt problems for over 40 years. You can reach Brian at (905) 576-3430 or bpritchard@bdo.ca.
*Office of the Superintendent of Bankruptcy
** The Globe & Mail – mortgage rates – August 26, 2005
*** Canada Mortgage and Housing Corporation
