Subprime Loans: The Loans Behind The Mortgage Meltdown
Not too long ago, when a homebuyer needed to secure a loan, they were pretty much limited to applying for a conventional mortgage. These types of loans were generally noted as having a fixed rate and term, 15 or 30 years. They required mounds of paperwork and a reasonable amount of due diligence on the part of the lender to ensure that the borrower could indeed afford the mortgage without inflicting financial hardship. As a result, foreclosures were not a common occurrence and conventional lenders pursued foreclosure against a borrower only as a last resort. Times have definitely changed and so have the sheer number of foreclosed homes across the country. Loan delinquency rates and foreclosure activity is higher among the subprime Adjustable Rate Mortgages (ARMs) market in comparison to more traditional prime loans. According to the Mortgage Bankers Association survey, subprime ARMs represent 6% of the loans outstanding and 39% of the foreclosures started in the first quarter of 2008. Out of approximately 516,000 foreclosures started during the first quarter 195,000 were from subprime loans.
Home Loans for Homebuyers with Poor Credit History
The most recent boom in real estate sparked a frenzy to qualify more homebuyers. Many buyers had less than perfect credit that often disqualified them from receiving a loan under conventional mortgage guidelines. Enter the subprime lending market which crafted several “creative financing” products for those with less than perfect credit. The subprime home loan market grew from $35 billion in 1994 to $600 billion in 2006. Subprime lenders boasted that their loans had assisted in boosting U.S. homeownership to a record 69 percent of households. Unfortunately the machinations of subprime lending practices have resulted in a mortgage meltdown as the numbers of borrowers in default increase and the volume of foreclosure listings balloon. There are three loan types that are linked to the mortgage meltdown: No or low-doc loans, Option ARMs, and Hybrid ARMs.
In the 1990s low-documentation mortgages comprised a small fraction of the market but became a large segment by late 2006. According to the Wall Street rating agency Standard and Poor the number of low-documentation mortgages increased 50% from mid-2005 to mid-2006. Low-doc or no-documentation mortgage applicants have to have good credit histories but their income and assets are not verified.
There are three main types of low-doc/no-doc mortgages:
- Stated- income mortgages: Applicants must disclose annual earnings from the last two years. Instead of backing up their income claim with pay stubs and W2 forms, the borrower might have to show tax returns, bank statements and profit-and-loss statements. The borrower must disclose their assets and debts.
- No-ratio mortgages: Applicants do not declare income. No pay stubs, W2s, or tax return information is required. No debt-to-income ratio, required for most loans, is calculated. The applicant is required to list their assets and have a good credit score.
- No-income/no-asset verification mortgages: Sometimes known as NINAs, these loans need the least amount of documentation. The applicant provides their name, Social Security number, amount of the down payment, and the address of the property being purchased. The lender does a credit report and a property appraisal and that is it. An excellent credit score is needed for this type of mortgage and NINA mortgages have a higher interest rate than conventional mortgages.
In 2003 option ARMs accounted for as little as 0.5% of all mortgages written in 2003, but shot up to at least 12.3% in 2006. Stock and bond analysts estimate that as many as 1.3 million borrowers took out as much as $389 billion in option ARMs in 2004 and 2005. Payment-option ARMs offers the borrower the choice and flexibility but can prove costly if they don’t fully understand their options. For a set period of time, fully described and determined in the signed mortgage, borrowers can choose the type of monthly payment from four options:
- A minimum payment that does not cover interest. This option increases the total loan balance
- An interest-only payment that does not reduce the total loan balance
- A payment of interest and principal that pays off the mortgage in 30 years
- A payment of interest and principal that pays off the mortgage in 15 years
Mortgage payments are set to increase after the option period. For borrowers who choose the first payment option, payments increase before the option period ends. The unpaid interest is added to the balance of the loan so that the loan balance increases. This is called ‘negative amortization”. When the loan balance reaches a certain amount, specified in the mortgage, the payments will increase regardless of when the option period ends. The borrower must then pay higher loan payments to lower the balance of the loan. Paying only the minimum payment can increase the loan amount to the point where the borrower owes more than the home is worth.
Hybrid ARMs can have two, three, five, or ten years of low-interest fixed-rate payments but after this period the loans reset at a much steeper rate. This can prove fatal for homeowners that cannot handle higher payments. Hybrid ARMs offer easy lending terms but include the possibility of hefty rate increases in a few short years. These loans were created for wealthy individuals with fluctuating incomes but were peddled to middle and lower income families over the past 10 during the nationwide housing boom. Hybrid ARM loans had minimal underwriting requirements that allowed borrowers to purchase homes without assessing their ability to handle payments over the life of the mortgage. In 2006 more than $300 billion and in 2007 approximately $1 trillion worth of hybrid Arms readjusted for the first time.
The option ARM is probably one of the riskiest and most complicated home loan products ever created. It lures homebuyers in with promised low minimum payments that are only temporary. The less a borrower pays monthly the more is tacked onto the balance. Many of the ARMs taken out in 2004 and 2005 are resetting at a higher payment schedule and because home prices are declining, borrowers can’t count on the equity in their homes to help them out. Another sad fact about option ARMs, steep penalties are assessed to borrowers who attempt to refinance their loans.
Hybrid and Option ARMs were attractive to many borrowers because they often offered a low introductory interest rate, no money down or interest only payment teasers. Combine that with lenders who underwrote those mortgages without requiring adequate proof of the borrower’s assets and income and you set the stage for a climb in lender and bank foreclosure rates.
Many critics of these loan products had long protested what they called the predatory terms of these loan products. However, it did not stop many borrowers from signing on the dotted line. Maybe they didn’t understand what they were agreeing to or thought that circumstances would change and they could afford a larger loan payment two or three years down the road. However, the reality is that many probably could not realistically meet their loan terms then and definitely can not afford it two or three years later as those terms reset to reflect even higher interest rates and payments.
The Center for Responsible Lending believes it will also get worse before it gets better. At a March 2007 hearing in front of the U.S. House Committee on Oversight and Government Reform, they predicted that foreclosure rates would increase significantly in many markets and that 2.2 million borrowers