August 30, 2009

Unfortunate Example of a Family that got In Over Their Heads

A few nights ago my wife and I watched an episode of the program Flip This House. The episode in question featured a regular house flipper on the show traveling to San Clemente, California to attempt to "rescue" homeowners who were having difficulty finishing their home remodeling job. The homeowners were way in over their head in their home remodel and in serious financial jeopardy. Unfortunately In the end they lost the home along with significant amounts of money they had invested.

Summary of the situation:

The home owners had bought their house for about $600,000. Then put about $500,000 into remodeling the home. Unfortunately they got taken advantage of by a bad contractor and had about $200,000 of their work (or more) go to waste. Then the homeowner lost his job. This put them in a tough spot with a half remodeled house, no contractor, large debt payments and no income. So at this point the show stepped in to try and help. During the show they put another $200,000 into the home and were able to get about $150,000 of debt on a secondary mortgage forgiven. They still owed the banks over $600,000 and owed family about $300,000. During the show they hired a new contractor and got the home completely finished. At the end of the show they were thinking of putting the market on the house for $1,300,000 and the math added up that they would walk away with all the debts paid and a 'profit' of about $50,000. Unfortunately the house didn't sell and they had to drop the price further down to $1,100,000 but it still didn't sell. Eventually they lost the home to foreclosure but walked away with $15,000 cash from their equity.

Basic points:

Family bought home for $600k
Put $500k or more into remodeling
Tried to sell at $1,100,000
Lost home to foreclosure and got $15,000 cash

In the end it seems they lost nearly $500,000 in the deal all together. Ouch.

I should point out that in the 1 hour TV episode you only get bits of the story and the entire picture is not too clear. The TV program is also edited by the producers so we don't now what they chose to show and not show. I'm taking what I saw on TV at face value and I don't know the whole story.

The biggest problems

Job loss: The guy lost his job. If he still had his job he probably would have come out ok. The show didn't go into the couples finances too much and we don't know what his income was, but it seemed clear his problem was currently mainly due to lack of income.

Bad Contractor: The first contractor skipped out and didn't finish the work. Homeowners doing a remodeling job are dependent on the reliability of the contractors and there are a few bad contractors out there.

Bad housing market: The show seemed to be taped late last year and by the time they put their house on the market it was December 2008. If all of this had happened 2-3 years earlier before the housing bust then they may have been able to quickly sell their house for a tidy profit. But the timing was such that they hit the worst of the housing slump when it was not only very hard to sell a house but prices were continually dropping.

Some things that exacerbated the situation

During the show the couple seemed to be living in temporary housing in either some sort of motel or an apartment. So they were paying extra bills for that housing in addition to the mortgage on the home. The couple had pretty high end tastes on some items and the show featured an argument where the wife insisted on getting smooth surface stucco on the home which costs $5,000 extra.

What could the homeowners have done different?

Job losses, bad contractors or housing busts are not entirely within our control and its possible those things could happen to any of us. But what could you do to keep from getting into this kind of situation?

Probably the safest way that they could have avoided this whole mess was to not attempt to build their dream home the way they did in the first place. They should have lived with the $600k home in the state it was and keep their cash in the bank. You shouldn't try and buy or build a >$1M home unless you can truly afford it.

Don't take on too much debt. You really don't want to have a $1M home with a $900k loan on it. That is leveraging too high. You should always consider the worst case scenario such as losing your job and think how you would be able to support yourself. Having high debt level is a invitation for disaster.

Build a bigger emergency fund. He may have had a decent emergency fund but it apparently didn't last a year. If you have a high liability like large mortgage debt then this is a good reason to build up a bigger emergency fund.

Instead of buying a house and undergoing a major remodeling project that you self fund or get additional loans for, they could have just saved up the money and bought a finished home of their dreams. This way they wouldn't get stuck in a bad remodeling effort and theres no risk of having problems with contractors.

Undertake remodeling work in phases rather than attempting to remodel the entire house. They could have redone things a step at a time with cash rather than trying to tackle the entire house at once. Its possible that they did do this in fact, but the show didn't go into much detail on their remodeling efforts previous to the program.

Its unclear how well they investigated contractors but the show did say that they hired the cheapest contractor. Its possible that they could have avoided all their problems by doing more research and hiring a more reputable contractor with a solid established reputation for doing good work at a fair price. Instead it looks like they may have just 'cheaped out' and hired the lowest bidder.

I feel bad for the people but its possible the situation could have been avoided if they hadn't been so ambitious or if they were more careful with things. It really does seem that the problem should have been avoidable.

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