Real Estate Insights

What started as a good idea to help certain homeowners facing financial hardships get back on their feet has been vilified and turned into a scapegoat in the aftermath of the recent real estate bust. But, are these subprime mortgages evil? Anyone who has been in a financial pinch would agree that a financial tool that could provide debt relief would not be a bad idea. When used properly, these mortgages can make the difference between keeping your home or being forced to sell. In a way, these mortgages gave many homeowners a fighting chance to stay in their homes.

Who would ever want a subrpime mortgage?

Let’s imagine that your neighbor has owned his home for over the past 10 years. Lately he has been going through a lot of financial turbulence. Maybe his parents have fallen ill or he has lost his job. Either way, his income is no longer where it used to be and over the past 10 years he has accumulated a lot of consumer debts; his new car loan, his wife’s new car loan and maybe his daughter’s new car loan.

And, because of medical problems he has stacked up a lot of credit card debt and since he lost his job he doesn’t have health insurance that will cover the cost of his medical care, so he probably has a few medical collections.

Recently he has fallen behind on his monthly bills because he has been overextending himself. Now he is facing not being able to make his mortgage payment next month.

Now imagine that this is actually you we are talking about, not your neighbor. It’s scary if you realize how fast this scenario can become your own.

So what can you do once you realize that you cannot afford to make the next month’s mortgage payments? You might end up consulting with several banks or mortgage brokers. The banks will most likely all agree that because of your current financial position; lack of income, assets, and terrible credit due to high balances and medical collections; they will not approve your application for a refinance even though you have been an account holder at those banks.

The mortgage broker, however, because he has the ability to search hundreds of lending institutions, has offered you a refinance that will make it affordable to continue living in your home. With this refinance you will be able to pay off your high balances on your consumer debts and keep your monthly mortgage payments equal to what you are used to paying.

So what’s the catch?

The mortgage program that the mortgage broker has offered is called a subprime mortgage because it is being offered to a borrower of sub-prime qualifying characteristics – your credit is terrible, you do not have many verifiable liquid assets, and your income level has diminished. But, because of the terms of the new mortgage, the lending institution making the loan will overlook you recent misfortunes.

The terms of the loan are very aggressive. The interest rate offered will be equal to or lower than your current interest rate and fixed for 2 or 3 years only, the monthly payments will be interest only rather than full payments of principle and interest, and there will be a one or two year pre-payment penalty. Once the initial fixed term of this loan has passed the interest rate may re-adjust every six months and will usually be significantly higher than the initial fixed rate (the start rate).

How can this loan benefit the borrower?

As long as the borrower understands that the new home mortgage being offered is only a temporary fix for his financial hardship, the subprime loan will allow the borrower to restructure his debt, restore his credit rating, reestablish his savings, and get keep him in his home. If the borrower follows these steps then they will be able to successfully refinance out of the subprime mortgage by then end of the initial fixed rate period and qualify for a better prime loan.

Those borrowers who have relied on subprmie loans to help them reestablish their financial positions understand their importance as a financial tool.

Why do subprime mortgages have such a bad name?

The problem with these loans is that they can be devastating to a homeowner if used in the wrong way.

Imagine if the borrower from above did not use this mortgage correctly. Instead of actively restoring their credit or reestablishing their savings, they decided to take on more debts. After the refinance, they now had an abundance of cash flow freed up and…hey if the banks were willing to give me the last loan, then they will be willing to bail me out again…except that either the banks offering these loans were no longer in business or the borrower’s home no longer had enough value to support another refinance. Either way you look at it, this scenario would be devastating to the borrower because one their loan becomes adjustable their payments were likely to double leaving the borrower with the likely outcome of foreclosure.

Add to these unlikely scenarios the sad reality over the past few years that many homeowners were put into this type of loan unwillingly or unknowingly and when the borrower realized that they were duped either from their own carelessness or out of the unethical practices of their mortgage originator, the borrower faced large pre-payment penalties that kept many of them from refinancing.

What will come of the subprime mortgage?

It’s not easy to say since the media has portrayed the subprime mortgage as the single handed cause of the real estate bust. But before you jump on the bandwagon and condemn this mortgage program to it’s certain financial death, just think about what you would do if you needed this mortgage program but it was no longer available. In fact, the subprime mortgage was a about the most valid home financing innovation from the nineties that enabled over 12 million households to become homeowners and allowed many others to stay a homeowner, of which a large majority of these would have been denied mortgage credit otherwise. And, by keeping these borrowers in their homes, subprime borrowers are actually increasing their net worth through capital gains, the standard American way for building wealth.

So, the Subprime mortgage market, for all its warts, is a promising development, permitting low-income and sub-prime borrowers to participate in certain credit markets. The industry does need to be cleaned up and regulated, but let’s not throw the baby out with the bath water. Instead of destroying financial innovation, let’s get cracking on fixing the problems.