Subprime Mortgage Lending - Pieces of the Puzzle

The current housing market is disastrous. More than that, it is also something of a puzzle. There are several elements that have worked together here. If you understand each of these elements, you'll see how they fit together, and how the puzzle has grown. We should hardly be surprised that subprime mortgages are being foreclosed at a great rate. How in the world did we let ourselves get into this situation? Read this article, and then you decide.

The "prime" rate is the rate charged by all banks in the country. The prime rate doesn't change regularly or often, only when 75% of the country's top 30 banks decide they need to change it. People who have a decent credit rating are usually given mortgage and other loans at prime rate.

Subprime borrowers are people who probably have pretty poor credit ratings. They may have a history of bad financial management, perhaps including collection accounts, repossessions, maybe even a bankruptcy. At any rate, they are perceived to be more likely than the average borrower to default on this loan. A subprime lender exists to lend money to borrowers who are not expected to act responsibly in the repayment of the debt. The interest rate that a subprime lender charges will be higher than usual because of that increased risk of default. Subprime lenders know about the risk; they fully understand that these borrowers cannot really be counted on to repay their debt. Why should they be surprised when it turns out exactly the way they expect it to?

Lending takes place when one business or individual lets out money to another business or individual, for a defined period of time, and at a specified rate of interest. When you're talking about a mortgage, it might be – for example – a fixed-rate loan for 30 years, at 5.7% interest. (The annual percentage rate is referred to as the APR.) This is a common type of mortgage: the borrower agrees to pay the lender back over a period of 30 years, at a yearly 5.7% interest rate.

So there are three elements of the puzzle: borrowing, subprime, and lending. What else has contributed to the current situation? Lending practices of dubious quality joined with a huge number of subprime borrowers whose ability to repay their loans was questionable. Yes, we are definitely in a mortgage crisis; foreclosures have never been higher. Whose fault is that?

When a homeowner falls behind in monthly payments on a mortgage, the bank takes notice. If payments are not made for three months, generally the process of foreclosure is initiated. This is a lengthy and costly process that often spans many months. The home is foreclosed and the property is repossessed by the bank.

Actually, the bank would prefer the borrower to repay the debt rather than have to take the property. A bank is not a real estate company. There is also the risk of censure from the federal government if too many of their loans are defaulted upon. For these reasons, foreclosures can take a very long time. The bank is in no hurry.

The majority of subprime mortgages are nowhere near as easy to understand as the example we gave above. Lenders have gotten more and more creative in the last few years, in an effort to attract more subprime borrowers. Many of these borrowers are now carrying an adjustable rate mortgage (ARM). The initial low interest rate of these loans allowed lots of people to get involved in a loan for which they might not have qualified otherwise. When the loan resets in about two years, the interest rate usually goes up considerably. In addition, some of these loans have prohibited refinancing in the first several years.

Borrowers, subprime mortgages, lending, and foreclosure have all worked together to give us this picture. Contributing in addition were falling house prices, rising mortgage payments, changing real estate markets across the country, difficulty of finding accessible mortgages, and a glut of houses for sale on a market where few people are buying. Here's the completed puzzle: the mortgage mess.

Subprime Lending: Trojan Horse Of The Home Loan Lending Industry

Home loan lending used to be relatively simple. Lenders were so hungry for business they readily accepted no-down mortgages, interest-only loans, and E-Z refinancing for borrowers with bruised credit. Recently, however, a wave of bad loans wiped out small independent mortgage brokers, devastated bad-credit lenders, and prompted the industry itself to tighten lending practices.

Today, it has become harder than ever for cash-strapped would-be homeowners to obtain home loan lending.

Who Is To Blame?
Experts blame subprime lenders for the recent home loan lending debacle. In the past, people with poor credit scores or large debts and modest incomes would not have been granted a loan. In recent years, however, a new breed of mortgage brokers - called subprime lenders - burst onto the market. Instead of denying loans to people with poor credit history, they let these people take out mortgages and then charge them higher interest rates to offset the high risks associated with the loans.

Such action on the subprime home loan lending front enabled a huge part of the population to own houses. Subprime home loan lending morphed dramatically from a start-up business into a $600-billion-a-year enterprise. The problem with high risks, however, is that they either pay off magnificently or go bust, and this is just what happened. The subprime market fell, and it was not long before homeowners who financed their purchase with subprime loans found themselves with foreclosure notices in their hands.

Stringent Loan Standards
When applying for home loan lending, expect more than run-of-the-mill scrutiny. The industry is cracking down on the so-called "liar loans." These are mortgages obtained without verification of the buyer's declared income, under a "stated income loan" or "no documentation loan."

Additionally, the home loan lending industry has become more conservative in attaching value to houses. Before, bankers generously appraised homes for so much more than they're worth. Today, the appraisal is based not on the recent market value of similar homes but on worst-case scenario market pricing. Worst-case scenario value is not the amount a house can be sold for, but the amount it will fetch once it goes into foreclosure.

The Silver Lining
That home loan lending implements stricter regulations is sure to dismay everyone, from borrowers to lenders . However, three good things can come out of this. First, inexperienced and even fly-by-night mortgage brokers will be driven out of business, leaving the home loan lending market to legitimate lenders. Second, with lenders no longer eager to grant high-risk loans, there will be more money and better rates for borrowers with sufficient downpayment and good credit. Finally, fewer high-risk loans that never should have been granted in the first place will be floated into the market. This will result in fewer homeowners being dismayed and losing their homes due to inability to meet payments.

Every story has a moral, and this article contains only one. If something sounds too good to be true, it probably is too good to be true. So when buying a house, do not be tempted to take shortcuts. Go the longer but perfectly legitimate and business-sound home loan lending route.

Subprime Mortgage Lending: What’s it All About?

Subprime Mortgage Lending - 2007 Statement