Lately the news has been full of stories about the U.S. mortgage crisis. People who purchased homes on adjustable rate mortgages are defaulting at record rates, leading to an unprecedented number of foreclosures. Understandably, this has many homeowners worried about how foreclosure will affect home prices in their neighborhoods.

Why Foreclosures Happen

In the broadest sense, a foreclosure happens when a mortgage borrower can no longer make house payments. The lender will evict the borrower’s family from the property and attempt to recover losses by selling the home.

In the past ten years, a combination of factors led many homebuyers to take on more housing debt than they could truly afford. First, the housing markets in many cities and states around the country experienced supercharged growth in home prices. As home prices escalated far ahead of wages, homebuyers were in a position of paying more.

Then, to enable buyers to purchase these costly homes, mortgage lenders developed a slew of new mortgage products. With endless variation, the general theme was the adjustable rate mortgage, or ARM.

ARMs are mortgage loans that offer homebuyers a low interest rate for an initial period of one to five years. After that point, the interest rate can vary upward or downward according to the market, or even the lender’s own preference. Low interest rates in the early years equate to lower mortgage interest payments, allowing buyers to qualify for the bank’s debt-to-income ratio of 30 percent. This type of lending was particularly popular in the subprime market, where more homebuyers with poor credit ratings could qualify for a mortgage.

Unfortunately, many borrowers believed they could easily refinance their mortgages before the ARM adjustments went into effect, or that the escalating home prices would allow for a quick and profitable sale. However, borrowers were caught by surprise when the housing “bubble” started to burst, home prices in many markets stagnated or dropped and interest rates jumped. Those ensnared in unfavorable ARM loans saw mortgage payments increase overnight. Stuck in homes they couldn’t sell, owing more than the houses were worth, many buyers defaulted on their loans. Foreclosures became inevitable.

How Foreclosures Affect Home Prices

Due to the convergence of falling home prices and rising interest rates, foreclosures are affecting almost every neighborhood in the country, from the very modest to the super-exclusive. For those homeowners fortunate enough to have avoided the ARM crisis, there is legitimate worry about how foreclosures on neighboring properties will affect their own home prices.

Foreclosures and Home Prices -- Financial and Perceptual  

Exactly how and why do foreclosures affect home prices? Two main factors are the financial and the perceptual. In the financial sense, foreclosures may affect home prices due to the common real estate practice. When real estate agents help homeowners set a listing price for their home, they use similar houses in the neighborhood to calculate the home’s likely market value.

Although agents will typically avoid using a foreclosure, in some cases it’s unavoidable. If the foreclosure homes have sold for a relatively low price, that can drag down the nearby seller’s likely asking price. Savvy buyers looking for a home in that neighborhood can even use foreclosure prices to pressure neighboring home prices downward.

The other big impact of foreclosures on home prices is perceptual. If a mortgage lender handles a foreclosure discreetly and is able to sell the home quickly, neighbors and potential buyers may never know the difference. However, if a foreclosed home sits empty for weeks or months without yard work and other maintenance, it can quickly become an eyesore, security risk and a red flag to potential buyers.

If you live near a foreclosed home in this condition, or if your neighborhood has several homes like this, it is likely that your home value will decline due to buyer perceptions. A home seller in this situation has little recourse, although the real estate agent or homeowners association may be able to offer some advice or assistance. In some cases, other homeowners near foreclosure homes take on maintenance and security themselves to help prevent reductions in their own home prices.

Foreclosures have a ripple effect through the entire economy. Homeowners accustomed to enjoying the upward trend in home values must now make the hard choice between riding out the uncertainty and getting out of the market before foreclosure. Understanding how foreclosure affects home prices can help homeowners make this tough decision.

Lately the news has been full of stories about the U.S. mortgage crisis. People who purchased homes on adjustable rate mortgages are defaulting at record rates, leading to an unprecedented number of foreclosures. Understandably, this has many homeowners worried about how foreclosure will affect home prices in their neighborhoods.

Why Foreclosures Happen

In the broadest sense, a foreclosure happens when a mortgage borrower can no longer make house payments. The lender will evict the borrower’s family from the property and attempt to recover losses by selling the home.

In the past ten years, a combination of factors led many homebuyers to take on more housing debt than they could truly afford. First, the housing markets in many cities and states around the country experienced supercharged growth in home prices. As home prices escalated far ahead of wages, homebuyers were in a position of paying more.

Then, to enable buyers to purchase these costly homes, mortgage lenders developed a slew of new mortgage products. With endless variation, the general theme was the adjustable rate mortgage, or ARM.

ARMs are mortgage loans that offer homebuyers a low interest rate for an initial period of one to five years. After that point, the interest rate can vary upward or downward according to the market, or even the lender’s own preference. Low interest rates in the early years equate to lower mortgage interest payments, allowing buyers to qualify for the bank’s debt-to-income ratio of 30 percent. This type of lending was particularly popular in the subprime market, where more homebuyers with poor credit ratings could qualify for a mortgage.

Unfortunately, many borrowers believed they could easily refinance their mortgages before the ARM adjustments went into effect, or that the escalating home prices would allow for a quick and profitable sale. However, borrowers were caught by surprise when the housing “bubble” started to burst, home prices in many markets stagnated or dropped and interest rates jumped. Those ensnared in unfavorable ARM loans saw mortgage payments increase overnight. Stuck in homes they couldn’t sell, owing more than the houses were worth, many buyers defaulted on their loans. Foreclosures became inevitable.

How Foreclosures Affect Home Prices

Due to the convergence of falling home prices and rising interest rates, foreclosures are affecting almost every neighborhood in the country, from the very modest to the super-exclusive. For those homeowners fortunate enough to have avoided the ARM crisis, there is legitimate worry about how foreclosures on neighboring properties will affect their own home prices.

Foreclosures and Home Prices -- Financial and Perceptual  

Exactly how and why do foreclosures affect home prices? Two main factors are the financial and the perceptual. In the financial sense, foreclosures may affect home prices due to the common real estate practice. When real estate agents help homeowners set a listing price for their home, they use similar houses in the neighborhood to calculate the home’s likely market value.

Although agents will typically avoid using a foreclosure, in some cases it’s unavoidable. If the foreclosure homes have sold for a relatively low price, that can drag down the nearby seller’s likely asking price. Savvy buyers looking for a home in that neighborhood can even use foreclosure prices to pressure neighboring home prices downward.

The other big impact of foreclosures on home prices is perceptual. If a mortgage lender handles a foreclosure discreetly and is able to sell the home quickly, neighbors and potential buyers may never know the difference. However, if a foreclosed home sits empty for weeks or months without yard work and other maintenance, it can quickly become an eyesore, security risk and a red flag to potential buyers.

If you live near a foreclosed home in this condition, or if your neighborhood has several homes like this, it is likely that your home value will decline due to buyer perceptions. A home seller in this situation has little recourse, although the real estate agent or homeowners association may be able to offer some advice or assistance. In some cases, other homeowners near foreclosure homes take on maintenance and security themselves to help prevent reductions in their own home prices.

Foreclosures have a ripple effect through the entire economy. Homeowners accustomed to enjoying the upward trend in home values must now make the hard choice between riding out the uncertainty and getting out of the market before foreclosure. Understanding how foreclosure affects home prices can help homeowners make this tough decision.