Mortgage Products Lead to Delinquency
Over the past several years lenders have aggressively sought borrowers. As the pool of conventional borrowers diminished, the lenders created new mortgage products. This was done to find more borrowers. The problem is that many of these unconventional loan products tend to create a higher rate of delinquency.
Adjustable rate mortgages (commonly called ARMs ) often offer an initially lower monthly payment, allowing borrowers to qualify for the loan based on their income level.
To understand these new mortgage products, you must first understand a conventional or “perfect” home loan, at least in the eyes and heart of the lender.
Consider a $200,000 home purchase. To a lender, the perfect loan is one to make to borrowers with:
Excellent credit
Sufficient income to make the monthly payment
Solid employment history
Few other monthly obligations that must also be paid
Solid collateral (the property being purchased is easily worth the amount being paid)
Down payment from the borrower of 20 percent or more
Reserve funds (three months or more of cash on hand)
When all of these factors come together, the lender has a “perfect” loan. While there is always some risk when money is loaned, by following these simple guidelines the possibility of a loan going into default status is minimized.
In this example the borrowers are making a down payment of 20 percent (or a total of $40,000) from their own funds. They have excellent credit. Their income level is sufficient to handle the monthly payment. They have no other installment loans. Their employment situation is unquestionable: They have been employed for more than ten years and there is no reason to assume their employment will not continue. They have cash in reserve, beyond the amount of the down payment and the closing costs. The property has been appraised for more than the $200,000 purchase. As a lender in the business of making home loans, there is no reason not to lend the money. It is a perfect loan.
It's when any one (or more) of these factors are not perfect that a home loan decision becomes more difficult. For example, the employment history may not be as stable, or there could be some questionable items on the borrower's credit report. It doesn't mean that the borrowers can't get a loan, but it does put more risk when making the loan.
Lenders are not quite as stringent when making home loans for the purchase of the primary residence. They believe that most borrowers will do everything they can to save their primary residence because it is where they live. And everyone needs a home.
Mortgage insurance is sometimes called PMI, which stands for private mortgage insurance. The federal government, through loan programs administered by the Department of Veterans Affairs (VA), Federal Housing Administration ( FHA), and the Department of Agriculture, provides mortgage insurance to allow home purchases with small down payments — from 0 percent to 3 percent.
For years the mortgage industry has made loans to people that do not have a 20 percent down payment. To make the loan, lenders required the purchase of mortgage insurance. This protected the lender, not the borrower, should the loan fall into default. If the borrower has only 5 percent down, the lender would make the loan but only with the purchase of mortgage insurance. Think about the example: a $200,000 home with a $40,000 down payment. Should the loan default, the lender would control a $200,000 property that only needs to net $160,000 if sold. That's a pretty comfortable position for the lender. When a smaller down payment is made by the borrower, the mortgage insurance protects the bank from any loss after a default as if the borrower had made a 20 percent down payment.
Stated income loans, sometimes called no income verification loans or no docs (no documentation), are an easy way to get into debt at a level that the homebuyer cannot afford. Just because someone will lend the money does not mean it makes financial sense to borrow it.
The problem for lenders is that there are not enough “perfect” loans available. So to keep lending money, which is how they make their money, they need to lend to people that don't fit the perfect loan scenario. To do so they create new loan products.
One of the specialized loan products recently marketed is the interest-only loan. This type of loan allows the borrower to pay only the interest for the first few years, which means a lower monthly payment during that time, before the principal is amortized in the loan. Other recent innovations are longer-term mortgages such as thirty-five or forty-year loans.
Stated income loans are available to those that find it difficult to provide verification of their incomes. These loans are particularly popular with the self-employed and allow mortgagors to simply state their income rather than provide documentation that proves their income.
The real problem with these unconventional mortgage loans is that there is a greater chance of default. This can happen easily and unintentionally. For example, a homebuyer agrees to an ARM loan, and an adjustment of the interest rate occurs. The monthly payment could increase hundreds of dollars. The difference between the old loan payment (the adjustment of the adjustable rate mortgage) and the newer one makes it impossible to make the monthly payment.
Mortgage lending ratios are the key as to how much money can be borrowed. Usually expressed as 28/36, these two numbers are the percentage of the homebuyer's gross monthly income. The first number is the maximum amount of the proposed housing payment. It includes principal, interest, taxes, insurance, and any homeowner's association fees. This means the total monthly housing payment cannot exceed 28 percent of the total monthly gross income. The second number is the amount of all the monthly loan obligations. This includes credit card payments, student loans, car loans, and other monthly debts combined with the proposed monthly housing payment. This combination (or total of all the monthly payments) cannot exceed 36 percent.
Decades of lending experience have proven the 28/36 ratios to be worthy measures of what someone can afford when it comes to housing expenses. Lenders have over time loosened these ratios, all in an effort to lend more money. Some lenders have offered lending programs where as much as 50 percent to 55 percent of the borrower's total income can be allocated toward a housing payment.
To qualify for one of the specialized lending programs, the borrower must seek a loan from a subprime lender. A subprime loan usually costs more by charging the borrower higher interest rates.
Other loan products also make it easier to finance a piece of real estate. Notorious are the mortgage products that offer 100 percent financing. Sometimes lenders offer first and second mortgages: an 80 percent first mortgage and a 20 percent second mortgage. This eliminates the necessity of needing any down payment. It is usually sold to a borrower as a method to avoid paying mortgage insurance. Some lenders go further. They offer 103 percent loans, or actually lend more than the property is worth. The extra 3 percent is used to pay closing costs.
All of these special financing plans or specialized mortgage products make it easier for the borrower to get the money needed to buy a property. The problem is that it is also easier for the borrower to get into a precarious financial position.
