Bloom's Blog

Sub-prime, Who's to Blame?

Sub-prime talk seems to have made its way to water coolers everywhere. Wall Street reports sub-prime lenders declaring bankruptcy almost weekly and it’s followed by talking heads suggesting federal legislation to fix the problems. Question is, …what really is the problem?

Sub-prime Explained

First, if you aren’t familiar to the topic, sub-prime refers to a broad classification of loans to individuals with less than “prime” borrowing characteristics (credit score, income to debt ratio, loan to value and payment history). These lenders have pushed the underwriting limits with stated income, marginal FICO scores, high loan to values (LTV) and derivative loan products.

The Option ARM Trap

The most note worthy of these derivatives is the “Option ARM” or an adjustable rate mortgage with the option of paying the full amortized payment, an interest only payment or a “minimum payment” which is often a teaser rate of 1 -2% for a limited initial term of the loan. Making this payment isn’t without cost, however, as the difference between the payment you make and the payment you actually should make is added on to the principal balance of the loan (known as negative amortization). Your loan grows rather than reduces.

While neg-am isn’t always bad, what most people in these loans don’t realize is if the minimum payment is made every month, the loan will “recast” when the principal balance hits typically 110% of the original principal amount borrowed. This usually occurs just before the third year and can cause the payment to double, with no option to pay less than the full amortized payment at the full interest rate (index plus margin). If the index is LIBOR, for example, you could go from paying 2% to 9% when recasting occurs.

Here’s the trap. Because the initial payment is so low, a borrower can qualify for more loan than they can really afford to pay based on income. There is an incredible false sense of cash-flow well being. The temptation of a bigger house or nicer neighborhood is sometimes all too alluring. When that real payment kicks in most people either have to: 1) refinance with the same type of loan again (expensive), 2) sell (disheartening), or 3) in some cases default and be foreclosed on (expensive and disheartening).

Who’s To Blame?

It’s entirely possible to end up owing more than the house is worth if the initial LTV is high and the market softens (like recent history has shown). But, back to my initial question… where is the problem and who’s to blame? There has to be a place to point the finger of blame. Right?

I think there is plenty of blame to go around. Many lenders were creating underwriting guidelines so that anyone with a pulse, many of whom didn’t have legitimate or sustainable means to make a mortgage payment, could get a loan. Plenty of brokers were doing only half their job. Sure they got people into new homes with big smiles, but they didn’t explain the consequences of making only minimum payments and the bind they would be in by doing so.

Finally, many people were simply interested in the immediate gratification and justified a bad decision with the hopes of better income or a profitable sale a few years down the road. After all, we just finished a stretch where home value appreciation saw prices double in as little as 5 years. It was bound to last forever.

What Should I Do?

If you have an Option ARM that is set to recast, refinancing with another one may be your only option to buy some time in the hopes that your income or house value rises substantially within three years. This will either allow you to make the “real” payment or sell without a loss and get into a housing situation that is more affordable.

My advice is to be aware when recasting is going to occur and plan ahead. Too many people get caught off guard, get behind in payments and risk foreclosure. At a minimum, you can destroy your credit score in months and spend years rebuilding it. Talk to a mortgage professional, preferably me, and get advice if you can’t figure out when this event will occur. You aren’t alone. This has been a popular loan product for the wrong reasons.