Higher Cost of Owning vs. Renting Will Drive U.S. Foreclosures Higher

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by: Research Recap

Moody’s explains why it thinks mortgage foreclosures will continue to rise despite loan modification efforts.

In Moody’s ResiLandscape newsletter, Celia Chen of Moody’s economy.com notes that the cost of owning over renting is particularly steep for those who took out loans in 2005 through 2007, the group most likely to be under water. “The enticement to walk away from a mortgage will contribute to the expected rise in foreclosures.”

“While the cost differential between owning a home and renting, on average, has narrowed since the top of the housing market, owning a home is still slightly more costly than renting. For those borrowers who are currently at risk of defaulting, however, the cost of owning may well exceed the rental cost. Those who took out loans in 2005 through 2007 are likely to be the most under water on their mortgage, yet are saddled with the highest monthly mortgage payments. The prospect of a cheap rental makes it all the easier for such distressed, underwater homeowners to decide to walk away from their mortgages. This dynamic will contribute to the rise in foreclosures that we’re expecting.”

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The cost of owning compared to renting has come down significantly from the top of the housing boom, but still remains slightly above the norm as compared to the long run average of this ratio (see chart above). However, slow rent growth and a slight uptick in house prices have kept this ratio from falling in the past several quarters. Not only is the recession constraining overall demand for housing and placing downward pressure on rent growth, but many frustrated home sellers are renting out their homes, adding to the supply of rental units.

About 32% of all homeowners with a first mortgage were under water in the third quarter of last year. Many of these homeowners will choose between defaulting and struggling to pay off a loan for a home whose value may be years away from exceeding the value of the mortgage. Some of these borrowers will be able to cut their living costs nearly in half by becoming renters, making it easier to walk away from their homes and default on their loans.

The inducement is another reason we expect foreclosures to mount and efforts to modify distressed mortgages to disappoint until partial principal forgiveness becomes a reality.

Mounting foreclosures will further depress house prices, sending the price-to-rent ratio down to its long-run average by year end.