Disasters and the Mortgage

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after Katrina I am upside down with my mortgage. my house is uninhabitable. My flood insurance check doesn't payoff the mortgage. How can i get a short payoff due to financial hardship - i.e. relocation loss of jobs and steady income?

This is one of the hard truths about mortgages. They are a contract between you and the lender to pay back a certain amount of money that you borrowed in order to purchase that property. They have nothing to do with any unforeseen hardship, and if you do not pay that money back, in full and on schedule, you can anticipate negative consequences no matter how good the underlying reason. Especially to your credit, and those are going to be long term consequences indeed.

Now unforeseen disasters, like Katrina, Earthquakes, floods, fires etcetera, are one of the biggest reasons why things go wrong with your ability to repay that money. Something happens to the property and now you can't live in it, and you do need to pay for housing elsewhere. Furthermore, in widespread disasters like floods and earthquakes, since your job may no longer be there, you may have to relocate a considerable distance away in order to find work, and have difficulty paying your mortgage even if your property, in particular, came through just fine.

There are several issues that trap the unwary or uninformed consumer. Homeowner's Insurance in general is the first of these. Many lenders in other states have requirements that the property be insured for the full amount of all mortgages against the property. This requirement is illegal in California (and a few other states), and actually is counter-productive as this implies that the objective is to pay off the lenders, when the objective of insurance is to repair the damage. The phrase that California lenders look for in the policies of homeowners insurance that any lender can and all lenders do require is "Full replacement value." In other words, the insurer must agree to bring the property back to being in the same condition it was in prior to the covered event that caused the damage. Nonetheless, there are many properties where this kind of coverage is not available, most often due to their location in areas vulnerable to periodic fires. In such instances, you can expect lenders to require significantly larger down payments and charge higher interest rates, if they are willing to lend against the property at all. Since in the current "Everybody buys with 100 percent financing" trend this severely impacts your ability to sell your property, and therefore the value you will receive for it, you should be advised of the difficulty before you purchase the property, no matter how much you have for the down payment. An agent who doesn't tell you about this issue on properties where it is an issue is either incompetent, or not looking out for your best interest.

Another issue with homeowner's insurance is that you must keep the insured amount reflective of your home's current value. If you bought ten years ago here in San Diego, you probably paid about $150,000 for a three bedroom single family residence. I don't know of any single family residences below about $350,000 now, and most are in the mid 400s or higher. The insurance companies, quite reasonably I might add, take the position that even if you have "full replacement value" coverage, your home is only insured for $150,000, and is worth $450,000, you are not insuring it for the full value and will not pay the full bill for any repairs even if it is only for $100,000. In such a case, it's been a while since I went over the figures that are the legal basis for the math, but in this particular instance, I get that the insurance company will pay $41,666 out of that $100,000 repair bill in this particular instance. The threshold is legally if you had the property insured to at least eighty percent (80%) of its actual value, they will pay the full bill, but you only had it insured to 33 percent of the value, and therefore they will only pay 33/80ths of the bill. So once every couple of years (more often in markets rising 20% per year!) talk to your insurance company about making certain your property is properly insured. Yes, you'll pay more money, but it is a trivial amount compared to the cold hard fact above. My first property has multiplied in value by about three and one half times, and the difference between the insurance premium then and the insurance premium now is less than fifty percent. Now some insurers (mine among them) have a good record of not invoking the 80 percent rule I'm talking about here and paying the full amount, but this is a matter of company policy, not legal requirement, and it can be changed at any time and no matter how benevolent they are, if the disaster is bad enough they will have no choice. Furthermore, those folks who keep their coverage updated are de facto paying for those who don't under such a policy, and for those who do make a habit of keeping their insurance coverage updated may find more competitive rates with other insurers.

Two things everybody needs to be warned about is that no regular policy of homeowner's insurance, not even the vaunted H.O.3 policy with the H.O. 15 endorsement, covers against flood or earthquake. If possible flood or earthquake is an issue where you are, you need to buy a special policy to be covered by them. Flood and earthquake policies usually have a higher deductible than a basic homeowner's policy, and the reason for this is simple: solvency of the insurer and price of the insurance. Flood and earthquake are typically widespread devastating disasters that make for major damage over a widespread area. If the deductible was smaller, the price of the added policy would need to be much higher, as paying off such claims strains the financial resources of even the strongest insurer. Now if you're buying on stable soil atop the highest ridge line for miles around, flood insurance is probably not a worry for you. I sit roughly two tenths of a mile from a creek bed, but the amount of territory it drains is relatively small, only a of couple square miles, as the big watercourses go well away from where I sit and there are large hills between me and them. On the other hand, being in California, I've had earthquake insurance since the day I bought the property.

One more thing with flood insurance: There is a federally mandated thirty day waiting period between application and payment of premium and the time it goes into effect. This is to prevent, for instance, people in New Orleans waiting until there is a hurricane headed their way and rushing out and buying flood insurance, then canceling it and asking for a return of their premiums afterwards. I think the thirty day requirement is waivable to the extent that it can go into effect on the day you buy your property, but talk to your insurance agent.

Now, one final thing to be aware of. The value of the land itself is not insured, only the value of the improvements to that land. If a flood goes through your land, the land will still be there afterwards (and research riparian rights sometime if you're worried it will not be - another thing a good agent should warn you about if it's relevant). So if, like many in San Diego, you bought the property for $500,000, but it only cost the builder $200,000 to put the property together, the value of the land is obviously $300,000, right? Well, your mortgage is for eighty percent or ninety percent of the value of the improvements plus the land. Let's say 80%, $400,000, although I suspect that's on the low side of both mean and median. So when a disaster destroys the improvements (i.e. the home) and your insurer sends you a check to rebuild those improvements, that $200,000 check is obviously not going to cover the full amount of the mortgage. What do you do?

Well, that's where the importance of a good insurance policy, that will cover the costs of housing while you rebuild in addition to the costs of rebuilding the home in the first place, comes in. You'll also need to learn the value and importance of managing cash flow versus amount you may owe, but that's a subject for another essay and you should consult a good professional financial person if you haven't learned this before said happens in any case. Trying to learn that financial skill "as you go" is a recipe for guaranteed disaster. Furthermore, no matter how good your policy of insurance is, there is always a deductible and there are always extra expenses of rebuilding that you need or desire to undertake because it's the best and cheapest time to do so. This illustrates the value of building up and maintaining an emergency fund that you can access, because even if the finished property will be worth far more, no regulated lender will touch a refinance for cash out while the property is still under repair. A "hard money" lender might lend you new money, but they require so much equity in the property "as it sits right now" that this is not an option for the vast majority of all property owners. And in the meantime, you must keep up all payments required under the original loan contract you agreed to.

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This page contains a single entry by Dan Melson published on February 11, 2008 7:00 AM.

When You Should Not Buy Real Estate was the previous entry in this blog.

The Self-Fulfilling Prophecy of Lender Fear is the next entry in this blog.

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