Monday, March 26, 2007

What's The Deal With This Sub-Prime Mortgage Thingy?

New York Newsday
Schumer urges more regulation of subprime mortgage rates
March 25, 2007, 12:19 PM EDT

NEW YORK (AP) _ Sen. Charles Schumer warned Sunday that 91,000 New York families are at risk of losing their homes when the rates of their sub prime mortgages increase, and said more federal oversight is needed in the sub prime lending market.

"The subprime market is the wild west of mortgage loans, and it's time we bring a sheriff into town," Schumer said. "The first step is making sure that borrowers are protected from these usurious lenders.
A lot of bloggers have been bringing this issue up, especially Atrios over at Eschaton. What has been lacking is, a reasonable explanation of what the heck the issue is. Soooooo.... a primer.

What is a mortgage?
A mortgage is a lien that constitutes a loan on Real Property.
In English: The mortgage contract, like most contracts, involves an exchange of considerations, things that have value. In the case of a mortgage the borrower is voluntarily allowing the lender to place a lien on the property. That is the mortgage, it is not the loan. This is why the borrower is referred to as the mortgagor, while the lender is the mortgagee. The borrower gives the lien and then lender accepts it. The loan is represented by the promissory note which amongst other things gives the bank the power to foreclose should the borrower default.

What are all these interest rates?
Interest Rate: a fee charged by a lender on the note of a loan.
Discount rate: The rate banks are charged on short term loans from the Federal Reserve.
Prime Rate: Rate charged by lenders to their best customers. i.e. least risky
Sub-prime: Rate charged by lenders for loans to high risk borrowers.

Okay now that we have that settled here is the story. SUBPRIME loans are mad to people who either have bad credit due to a bankruptcy, poor payment history, etc. Most SUBPRIME loans, eventually involve an adjustable rate that is higher than prime due to the increased risk. This rate "resets" periodically based on the US. Dollar, London InterBank Offering Rate (LIBOR) index.

The most popular type of sub prime lending is the 2/28 A.R.M.. The first two years of the loan are at a fixed rate but the NEXT 28 years are adjustable and can have severe consequences for the borrower. The primary reason to take a loan like this is to REBUILD your credit over the two years fixed and then refinance into a fixed rate, i.e. DO NOT LET THE ARM kick in. In short the 2 year fixed rate is a "teaser" sometimes below the rate for a 30-year fixed, then when the arm kicks in the interest AND the payment can go up dramatically.

The trouble for most people is they get suckered in because they are extremely vulnerable and the lender is a predator.
Ms. Needmoney goes to Chetum loans. Mr. Shifty the loan officer/banker/broker offers Ms. N a zero down 2/28 sub prime mortgage. The rate is 1.5% lower than the fixed rate of 6%.
Even here the story can go horribly wrong. Is the lender a sub-prime lender only? What if Ms. Needmoney COULD qualify for a prime rate mortgage, BUT since her chosen lender only makes sub-prime loans? He might "forget" to tell her that she could qualify for a prime and then refer MS. N to a prime lender. Back to the story.....
WOW! Thinks Ms. Needmoney, this is great! I can get a home for my family and the payments are so low! For two years, Ms. N makes her payments and then she applies to roll into a fixed; but finds that she still cannot qualify. The ARM rate resets that year for 2% higher , a full point higher than the fixed rate, and her payment goes up to adjust for the rise in interest. Ms. N now has a payment she cannot make and her credit rating plummets as she tries to make payments, pay bills, and raise a family.

End of story: Ms. Needmoney's dream has become a nightmare and foreclosure is sneaking around the bend.

(Click for larger picture)

Why? If we look at the example chart. Ms. Needmoney loan of 400,000 starts at 5.5% with a payment of $2271.18 however with the reset of adjusting .5% every year after the two year fixed she could pay up to 3,488.68 per month, based on an interest rate cap/ceiling of 15%. her monthly budget will have to adjust to eventually absorb a $1200 difference in mortgage payment.

Hope this helped and I will be back with more on this topic.

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