Why do falling home prices create an incentive for homeowners to default on their mortgages even if they can afford to make the monthly payments?
Home Mortgage Loan:
This question requires a basic understand of a home mortgage loan. A home mortgage loan is a debt financing arrangement, whereby the borrower (homeowner) has secured financing from the lender (mortgage issuer) by pledging the home as a collateral. This means the lender has a claim on the property, if the borrower defaults on the loan.
Answer and Explanation:
Home mortgage loans typically require a minimum loan-to-value (LTV) ratio. For example, an 80% LTV ratio means the lender will supply financing for 80% of the value of the home. So, for a $100,000 home, the loan amount could total $80,000. Now, let's assume the value of the home plunges from $100,000 to $60,000. The borrower owes the bank $80,000 per the loan agreement, but his home is only worth $60,000. As a result, ethics aside, the borrower is $20,000 better off by defaulting on the loan and allowing the bank to foreclose on the property.
This is how falling home prices create an incentive for homeowners to default on their mortgages, even if they can afford to make the monthly payments.
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from Finance 102: Personal FinanceChapter 7 / Lesson 4