The foreclosure crisis has been going on for a couple of years now, but it wasn’t until this week that it really hit home. My wife called last night to tell me that our former neighbors – I’ll call them Bob and Sue – had lost their house and would be moving to another state.
For background, I should note that Bob and Sue were part-time homebuilders for the better part of the past decade. While Bob worked full time and Sue stayed home with the kids, they also built houses on the side. Every couple of years, they’d start building a new house. When it neared completion, they would put it along with their current house on the market, and then live in whichever one didn’t sell.
Raising the stakes
This worked so well for them for several rounds that they eventually decided to start building more expensive homes – homes that they couldn’t actually afford to live in themselves if they didn’t sell. Unfortunately for them, they made this decision right around 2007. I’m sure by now you can see where this is headed…
As their the mega-house they were building neared completion, the bottom dropped out of the housing market (and the economy in general). Real estate stopped selling almost overnight, and they were stuck with two houses. They put the new one on the market for awhile, but there were no potential buyers.
Eventually, they put their current house on the market in hopes of salvaging the situation. Their plan was still to sell the mega-house if they could. But if they couldn’t, they would buy time by selling their regular home and using the proceeds to keep themselves afloat. Since they couldn’t afford the mega-house in the long run, they’d move into it, but leave it on the market and move again went it (hopefully!) sold.
Hitting rock bottom
After a few stressful months, they sold their regular home and moved to the mega-house. Sue also went back to work to help makes ends meet, and it seemed like they’d be able to stay afloat, at least for awhile. Unfortunately, “awhile” recently ran out. They fell behind on their payments, and the bank ultimately foreclosed on them. They’ve lost nearly everything.
In retrospect, it’s easy to say that they should’ve just let the mega-house go when the market tanked. Sure, that would’ve ruined their credit, but they were already in a house that they loved, so why not dump the mega-house and move forward? Now they have no house, no credit, and presumably little to nothing in the way of savings.
Well, for starters, Bob and Sue were intent on “doing the right thing.” They got themselves into this mess, and they were intent on getting themselves out of it. I respect them for that even though they’re now paying a huge price. At the same time, I don’t think they wanted to admit to themselves just how big a hole they’d dug for themselves.
With the story above as a backdrop, I wanted to share some financial lessons that can be learned from Bob and Sue’s plight. It’s too late for them to change course, but it’s not too late for others to learn from their mistakes.
Don’t be greedy
As much as it pains me to say it, Bob and Sue are victims of their own greed. Things were going so well for them that they decided to up the ante and start building huge homes that they couldn’t afford to keep. Sure, the profits would be bigger with their new strategy, but the risks were astronomically higher. In the end, they reached for the brass ring and wound up losing everything.
This is related to the point above, but it’s important enough to split out on its own… Risk is a funny thing. If you’ve ever read a financial book, you’re aware that “with risk comes reward.” But what many people often fail to realized is that investment risks are very real, and they’ll often rear their ugly head at the worst possible time.
It’s easy to be blinded by the potential upside, and to simply declare that they’re sufficiently risk tolerant to reach for higher returns. In Bob and Sue’s case, they let their risk/reward ratio got out of whack.
Let’s say they would’ve made $50-$100k by building and selling a “regular” house, and that the mega-house would generate $100-$200k in profits. In this case, they would’ve doubled their potential gain, but at what cost? Their downside risk went from being a manageable setback to complete financial disaster.
Leave a margin for error
And finally… Bob and Sue’s prospects apparently took a turn for the worse when he was laid off from his job. While they would have been able to pull this deal off if everything had gone perfectly, they didn’t have any wiggle room. And things didn’t go perfectly – the house didn’t sell, their income took a hit, and so on.
Unfortunately, even with Sue going back to work, they didn’t have enough cash reserves to carry them through the lean times. They took on such an extreme financial burden that they simply couldn’t make their plan work unless everything worked out perfectly – they had no margin for error.