While subprime lenders are getting hammered for the current state of the housing market, let’s remember that most of them are decent people – with creative programs – that filled a needed niche. Of the thousands of subprime loans in this country, about 13 percent are in trouble.
The subprime market’s reputation has been damaged by unscrupulous lenders who have taken advantage of borrowers unfamiliar with the mortgage process. They have not given enough time to explain the “worst-case scenario” payments and timeframes. Often, these borrowers have qualified for better rates and fees than they actually received but simply did not understand what they were signing. Bait-and-switch stories often surface and language challenges for immigrants are common.
Consumers also have played a major roll in the mess, by not asking enough questions or accepting loan terms they know would put them over the edge.
The history of the name “subprime” is interesting. All nonconforming lenders were once known as subprime lenders, a softer title than the “hard-money” moniker they wore a decade ago. (To further complicate matters, nonconforming loans are still synonymous with “jumbo” loans in many areas of the country). Now, it seems that any lender with a program other than a long-term, fixed-rate mortgage can be roped into the subprime category. “Creative” has become a nasty word when linked with “program.”
The traditional subprime borrower does not conform to standard credit, down payment income or job standards, and some lenders specialized in making those loans with higher rates and fees. There are people who have greater debt than others, and most of the time they will continue living that way. They simply live on the edge yet are committed to making their mortgage payments. Until recently, many conventional banks, savings and loans and credit unions would make nonconforming loans on a case-by-case basis.
But the past two months have been filled with accusations and a lot of inaccurate information about subprime mortgages.
First and foremost, a subprime loan is not any loan that comes with a balloon payment. Adjustable-rate mortgages (ARMs) with balloons have been around for years and are not new. The same goes for option ARMs, yet they all have been lumped into the subprime category.
Today’s environment can be compared to the era of payment shock brought by the early ARMs. Remember payment shock? That was the term used when consumers received their new loan payment coupons after their adjustable-rate mortgage underwent its first adjustment period.
First authorized by the federal government in 1981 but almost unused before 1983, ARMs supplanted a system of fixed-rate loans and stimulated a drowsy home market.
ARMs caught on quickly simply because the market needed them. As an inducement to borrowers, some lenders offered rates that were ridiculously low, qualifying borrowers for the first year of the loan but setting up potential bombshells shortly down the road – especially in a rising-rate market.
Heavily discounted one-year ARMs gave the new mortgages a bad reputation. When borrowers finished the first year of seemingly easy payments, the discounted rate ended and borrowers were forced into surprisingly higher, second-year payments, which resulted in the chilling reality of a monthly cash outlay commonly referred to as payment shock. However, lenders continued to refine and develop adjustable-rate mortgages, and most ARMs now contain one-year and “life-of-the-loan” caps that limit adjustments.
A program taking a lot of heat is the option ARM. The option ARM gives the borrower more choices over monthly payments each month, thus providing an opportunity to “flip-flop” payments according to household cash flow. After the initial start period, customers can select among four payments plans each month during the life of the loan. Borrowers are never locked in to one specific payment or amount, leaving open the possibilities of pulling back during a money crunch or shelling out more after an unexpected windfall.
Why, you ask, would you ever take out a loan where you owed more than you borrowed after a few years? In a perfect world, when you had all the money you needed when you needed it, you would never subscribe to such a deal.
But think about it: Will you have to refinance the house, or at least consider a home equity loan, to send kids to college? Or put mom in a nursing home? Or attend that mandatory family reunion? The option ARM is a vehicle that could shortcut that extra financing step by giving you more immediate control over cash flow.
The challenge for the borrower is having the discipline to flip back to a full payment. The challenge for the lender is explaining the consequences if that flip does not take place.
The problem is not subprime programs. The problem is being honest about what could happen when home appreciation does not cover the faults of a loan that should have never been offered or accepted.
Tom Kelly’s book “Cashing In on a Second Home in Mexico: How to Buy, Rent and Profit from Property South of the Border” was written with Mitch Creekmore, senior vice president of Houston-based Stewart International. The book is available in retail stores, on Amazon.com and on tomkelly.com.