By Lewis Smith and Frank Demarais
Alan Greenspan, former Federal Reserve chair for 18 years, stated in a recent Fortune magazine interview that “a lot of the subprime lending has been…in many cases, criminal fraud.” Here in the middle of the “subprime mortgage crisis,” it’s a good time to reflect on how to avoid being hurt when borrowing in the future. News reports state that up to 1 in 4 subprime borrowers are currently in default, and as many as 2 million homes will be lost to default in the next two years. This should be a wake-up call for many of us.
What Are The Features of Subprime and Non-Traditional Mortgages?
Subprime and non-traditional mortgages may have high rates, high fees, rate and payment adjustments, prepayment penalties and negative amortization. These loan types have built-in future changes which are often very hard for borrowers to understand and thus difficult to plan for. People take these loans because they often can borrow more than on a conventional fixed rate mortgage. People often overlook the highly negative terms, which can greatly hurt them in the future.
There are three main types of subprime and non-traditional mortgages.
First are “2/28s” which, after two years, begin adjusting every six months for the remaining 28 years. These sometimes have start rates close to standard fixed rate loans, but have high rate adjustments after two years and large pre-payment penalties to lock you in until that rate changes. Second are “Option ARMs” (adjustable rate mortgages), which have very low payments in the first five years that increase the loan balance through negative amortization rather than paying the balance down. Then, the option ARM, the industry’s most difficult-to-understand loan, converts to a much higher payment within five years. Third, are “Interest-Only mortgages,” with the payment shock of a much higher payment in five years when the full principal and interest payment must be made but for a shorter remaining 25-year mortgage term.
Is a Subprime Mortgage a Good Choice?
We believe that the short- and long-term costs far outweigh the benefits, especially for low- and moderate-income borrowers. If the only way persons can buy or refinance is by taking out a high cost, high-rate mortgage with a rising payment that will force another high-cost refinance, they instead should stop and take the time to improve their situation to get a stable, fixed rate mortgage.
In our experience counseling hundreds of low- to moderate-income homebuyers and homeowners, once people understand how a subprime or non-traditional mortgage works, most seek to get out of it to get into a stable, manageable mortgage.
How and What Can We Learn?
First, take the time and effort to carefully examine any mortgage proposal. Borrowers often do not do this. Too many people are enticed by, rather than are suspicious of, offers from brokers and lenders, which often sound too good to be true. This should be a big clue!
As a borrower, you are in control. While major bank lenders are often scarce in low- to moderate-income communities, start your search with the most respected national bank lenders. Obtain good faith estimates of closing costs and truth in lending statements and ask questions until you fully understand the numbers. If told that you qualify only for a mortgage with an adjustable rate, be sure that this is true. Seek out free, expert advice from nonprofit, US Housing and Urban Development-approved housing counseling agencies.
Second, borrowers need to consider the impact of mortgage payments on their family budget. Developing a family budget should be the first priority before buying or refinancing.
Third, people often don’t realize that home prices will not always rise in a straight line; and that if the value doesn’t go up, you cannot count on refinancing to get out of a bad loan. Too many people believed the loan officer who said, “Don't worry, I’ll refinance you before the payments increase.”
Fourth, some homeowners have used their homes as an ATM machine, repeatedly withdrawing and spending their equity to pay off short-term debt. They pay exorbitant fees of $7,000 to $10,000 on each refinance, which strips away their equity.
Fifth, people often avoid thinking about, and planning for what could happen in the future due to family needs, health and job changes. Any of these income or expense changes can affect their ability to keep the home when adjustable mortgage payments increase.
Homebuyers and refinance borrowers can take the time to learn, study and understand how a new mortgage will work and select a stable, long-term fixed rate mortgage. Alternatively, they can select the “too-good-to-be true” mortgage that may bring unpleasant surprises down the road.
Frank Demarais is vice president and manager and Lewis Smith is a mortgage counselor at Manna Mortgage, part of the Manna Inc. organization, which is located at 828 Evarts St., NE, and is the District’s first and only nonprofit mortgage company. For more information, call (202) 832-1845 or email Lsmith@mannadc.org. or Fdemarais@mannadc.org.