You Smelt it You Dealt it?

Flashback to third grade recess. Remember someone pointing out that the smelly kid, uh, smelled? And the smelly kid coming back with that endlessly witty "you smelt it you dealt it"? (Yeah, good grammar doesn't matter much when the source of bodily functions is at stake.)

The housing and financial crisis of 2008 and 2009 was a little like that.

When people began losing their houses right and left, bankers and financial experts claimed that homeowners had sought out more debts than they could afford and had racked up too much credit card and personal debt. Financial journalists and homeowners blamed the banks, saying that the banks were giving out mortgages too easily to people who shouldn't qualify. Then the banks started getting financial help from the government while people were losing their homes…and the whole conversation got school-yard nasty.

So, what's the truth? In reality, both sides made some big mistakes.

Banks were too eager to give mortgages to borrowers—and it wasn't just out of the goodness of their hearts, either. The more mortgages they sold, the more they earned back in interest.

And homeowners could have made better choices with their debts.

Making Choices

Let’s say you have a choice between a modest $300,000 bungalow or a $500,000 home with a gourmet kitchen and walk-in closets. Which should you get?

When it comes to houses, good things can come in small packages. There are a few advantages to buying a smaller home and having a smaller mortgage:

• Governments push more money into the mortgage system for small mortgages, so the interest rates on them are smaller.
• You'll owe less and your monthly payments will be lower.
• You'll pay less overall in interest on a smaller mortgage.
• You'll keep more equity in your home (that's the value of your home not tied up in debt).
• Smaller mortgages are more liquid (more people buy smaller homes than larger ones so it's easier to sell them if you have to).

If you have $50,000 as a down payment, the smaller $300,000 house would mean a mortgage of $250,000 at maybe 5% interest. Your interest would come out to $12,500 a year: a third less than the larger house. If housing prices went down, your house value would go down, too, but you wouldn't have as much of a mortgage to repay. Plus, even in bad times, people tend to buy smaller houses over bigger properties. If you absolutely had to, you might be able to find a buyer.

Maybe that $300,000 house went down 15% in value ($300,000 - $45,000 = $255,000). Let's say that closing costs are $5,000 and commissions when you sell are about 5%. Your commissions of 5% would be $13,000 and with the $5,000 in closing costs you'd have to subtract another $18,000 for a grand total $237,000.

You still owe the bank $250,000 and you're about $13,000 underwater if you pay them back using the money you got from selling your house.

But it's still oh-so-much better than what would have happened if you'd bought the $500,000 house.

Plus, living costs in the smaller house were less, so maybe you were able to put aside $30,000 or more in savings. If you did, you might not be underwater much at all…maybe just enough to breathe in some water. You'll lose the $50,000 down payment, but you can use that as a tax credit: as you have gains on future investments, you don’t have to pay taxes on them until you've made over $50,000 in profits.

It'll still sting, yes, but you won't be faced with a mountain of debt and no way out.