Subprime Market Boom
There had been a few rumors here and there for a few weeks, even months, about lenders “pulling in the reins” in the subprime industry. For the past four or five years, the subprime lending industry has grown exponentially–truly at an astonishing rate. Several of the largest subprime lenders saw their loan volumes double for three consecutive years. We’re talking hundreds of billions of dollars in new loans. A lot of that had been following the refinance boom in late 2003 when interest rates hit rock bottom and then 2004, which saw housing prices skyrocket. The combination of low interest rates, more expensive homes and more homes being sold overall led to a what lenders saw as a huge opportunity. As more and more companies entered the market, competition reached a fever pitch. In order to stay competitive, some lenders began making loans to, as one account executive said to me, “anyone with a pulse and a pen”.
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Incredible Loan Offers for Borrowers with Damaged Credit
As a broker, I would take a loan application, compile the information with a credit report and submit a short file to a handful of lenders whom I thought offered the best rates for that particular borrower and their situation. I had a borrower in mid-2004 whom had recently gone through a divorce and had to declare chapter 7 bankruptcy. The divorce totally wiped the borrower out, who was now moving on and buying another home. Obviously, he had no money for a down payment. A few years ago, this borrower would have had to rent for a while to rebuild his credit and save money for a down payment. However, many lenders guidelines had changed so much that I had seven different lenders competing for his loan, each offering 100% financing the day after the bankruptcy had discharged. Even more surprising, they were willing to do the loan for 6.25%, and make it interest-only for the first five years!
Housing Bubble Burst And Interest Rates Increased
This is just an example of how many different lenders had been competing so fiercely to reach out to new markets that they had made loans that were considered very risky. At the same time that the market became saturated with new lenders and even more loan products, the housing bubble burst, home values started to level off and the Federal Reserve continued to raise the Prime Rate. Through 2006, we saw housing prices continue to settle or even drop as the Prime Rate continued to rise from 4.0% in 2003 to its current 8.25%. During the period of 2003 to 2005, the majority of subprime mortgages originated were called 2/28 ARMs, where the interest rate was fixed for the first two years and then adjusted according to the market conditions. With interest rates on the rise, many people weren’t as prepared as they thought they were for the increased monthly payment. Late payments on mortgages skyrocketed and foreclosure rates peaked to their highest levels in years.
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Lenders Unable To Sell Off Loans
Most lenders will originate a large number of loans and then sell them off in pools or large groups to investors on Wall Street. This is also where the lenders obtain the supply of money to fund the loans they are originating. As the investors began to see reports of the tremendous increase in monthly mortgage late payments and foreclosures, they began to worry and quickly stopped supplying the lenders with the money need to fund the loans being originated. As one account executive told me, “overnight, 32 of our primary sources of funding were completely shut off”. Panic ensued, and lenders stock prices plummeted forcing some to file for bankruptcy, others to limit the types loans they could offer and a handful to completely stop accepting any new loan applications.
Lenders Tightening Standards – The Worst is Over
It’s been a few weeks since the initial flurry of activity and it seems that the worst is over. Many guidelines have been tightened, so that 100% financing one day out of bankruptcy will probably not be available. Many lenders are capping their Loan-to-Value ratios (the percentage of the purchase price or value of a home to which they’ll lend) to a lower level. For example, if a lender would normally offer someone with a 580 credit score 100% financing, they may now only be offering 90% or even 85%. It is important to note that with the rapid change in guidelines, lender offerings vary greatly, so check with your broker to see what is currently available.
The effects of this on the housing market may still be just beginning, but the tightening of lending standards has already been done.
Future Prospects of the Subprime Lending Market
That leads to the most important question: “Where does that leave me?” If you are a borrower with a blemished credit history, don’t count yourself out, even when it comes to 100% financing. While subprime lenders have been quickly tightening their guidelines, Fannie Mae and Freddie Mac seem to have been picking up the slack. In case you’re not familiar with Fannie Mae, it is a privately owned and operated corporation that is the largest purchaser and guarantor of home mortgages in the country. It was chartered in 1938 following the Great Depression and has been privately held since 1968. Freddie Mac was created in 1970 to help savings and loan associations (or thrift institutions, as they were known) distribute their loans in the secondary market.
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Fannie Mae and Freddie Mac Conforming Loan Guidelines and Loan Limits
Fannie Mae and Freddie Mac purchase, repackage and sell these loans into the secondary market to help maintain fluidity in the housing industry. They have conforming guidelines and loan limits that are universal that are generally more strict than non-conforming loans, which include subprime loans. Because conforming loans have more streamlined and universal guidelines, they are easy to sell to investors, particularly investors on the more conservative side, where their yield may not be as high as that of subprime loans, but their risk is significantly lower. When interest rates started to adjust and borrowers became late on their payments, these investors started to panic.
“Perfect Storm” Theory of the Subprime Meltdown
Many economists agree on the “perfect storm” theory of the subprime meltdown. Three things happened simultaneously: 1) borrowers incomes dropped; 2) adjustable interest rates started to rise dramatically as their initial adjustment period began, and 3) housing prices fell across the country. A record number of subprime borrowers purchased their homes when prices were at an all time high and many put little if any money out as a down payment. Thus, when the housing prices fell, refinancing or even selling their home was often not an option because of the lack of equity (partly due to no property value appreciation). Many borrowers were and still are currently stuck with increasingly high monthly payments with no way out. That has caused foreclosure rates to reach 13% in 2006, compared to 2.6% for conforming loan borrowers. Many predict that as many as two million Americans are now facing foreclosure.
Suggestions for Borrowers With Damaged Credit
That leads borrowers to ask the question, “what do I do if I have tarnished credit (or a lack of credit history) and want purchase my first home?” Although there is no absolute answer to that question, here are a few suggestions:
1) Increase your down payment on purchase transactions.
This is the most immediately effective way to improve your chances of obtaining a loan, but for most people, it is also the most difficult option.
2) Ask a family member or close friend for a gift as a down payment.
Lenders will allow this, as long as the giver signs a paper stating the amount they wish to gift to the borrower and that the money is money is not a loan; hence, they do not expect to be paid back.
3) Find out whether or not the seller is willing to assist with financing in the form of a second mortgage.
If you (with your broker’s help) can convince the borrower that loaning you the difference between what the bank will lend you and the purchase price (or difference between the loan percentage and your down payment), many lenders will allow subprime loans with up to 5% down of the borrower’s own money. Negotiate with the seller a short-term loan with an attractive interest rate and it will probably be in everyone’s best interest. You an purchase your home, the deal closes, and your seller is earning monthly income from you.
4) Take some time to improve your credit score and cash reserves or save for a larger own payment.
Obtain a copy of your credit report and dispute any inaccurate information on it. Try to pay down collections to below $250. Many lenders will forgive medical related collections, so start with any tax liens or other judgments against you and then work on reducing your revolving debt (credit cards, etc).
5) See if you are eligible for certain first time home buyer programs.
There are a vast number of programs out there for first time home buyers (Flex loans, My Community, etc.). There are also special programs for teachers, police officers, firefighters, and health care professionals. If you served in the military, you can probably qualify for 100% financing with a VA loan. FHA loans require only 1% down and are geared towards borrowers with less than perfect credit and lower incomes. This is often an excellent option.
Many first time homebuyers reflexively gravitated towards 100% or 80%-20% subprime mortgages and they seem to be the group that has been hardest hit by the recent “subprime meltdown”. As you can see, however, there are a number of options available to those who still need a high percentage of financing but would not qualify for a “prime” mortgage. Speak with a knowledgeable mortgage specialist to see what options you may be able to pursue.