What is a sub-prime loan and why are the folks in trouble? Simply put a sub-prime loan was a loan which offered people to purchase homes for which they were not qualified to purchase. For example, a lender might have offered a new buyer the opportunity to own their own home with no money down. Many of these loans offered various payment options. The traditional payment of principle and Interest fully amortized over 15 or more commonly 30 year periods. At the end of 30 years, you owned the home. One variation was to offer an interest only payment. In this scenario the buyer would pay the interest portion of the monthly payment onlyâ€”deferring the principle payment until the time of sale. In this scenario, a borrower never actually paid off the principle, but it helped many would-be homeowners become a "homeowner".
Here are three payment options many of these loans provided: principle and interest, interest only or negative amortization. A negatively amortized loan payment is less than a fully amortized payment or an interest only payment since the borrower is only paying a portion of the full inertest due and nothing towards the principle. In the following example we see what these three payment options would do to a homeowner’s payment.
Loan amount $300,000 Rate 6.5%
Principle & Interest payment $1,896.20
Interest only $1,625.00
Negatively Amortized $1,125.00 (4.5%)
As is evident, it was very tempting to opt for the negatively amortized loan since it dropped the out of pocket monthly mortgage payment $771.00. Of course this meant that the loan actually grew rather than diminished which is why it is called negatively amortized as opposed to fully amortized. The $500.00 difference between the interest only payment at 6.4% of $1,625.00 and the lower effective payment at 4.5% of $1,125.00 was added to the loan balance each monthâ€”though the payment stayed the same.
Why would anyone take out a negatively amortized loan? Simple; it made housing more affordable or in some cases more housing affordable. For investors, it freed up much needed monthly cash flow (money used to purchase other investment properties) and made owning investment properties where otherwise rents would not cover their expenses, affordable.
Why in many cases it didn’t work.
Banks made a huge error by aggressively qualifying the borrower at the artificially lower negatively amortized rate. In the above example, a borrower would only have to quality for the 4.5% payment instead of the 6.5% actually charged. Many of these loans were only capped at these lower rates for five years. When these began adjusting to higher interest ratesâ€”the actual market rateâ€” homeowners and investors alike found themselves in trouble.
For investors, owning a property where the rents no longer cover their expenses, no longer made sense and they began selling their properties as fast as possible. Since many of these investors took out the similar loans, many began adjusting at about the same timeâ€”flooding the market which speculative property sales.
Many homeowners faced with the same interest rate adjustment dilemma found they could no longer afford the monthly payment. In cases where they had put no money down, and opted for the negative payment, they soon found themselves with no equity eitherâ€”further tempting them into loan default status. Since they had nothing to lose, many simply walked away from their homes.
As one can imagine, with this many homes coming available at the same time, compounded by the overabundance of new construction, inventories rose at a time when buyers wanted out of the market. Fewer buyers, and more inventory equals lower prices, mortgage defaults and short sales where the lender agrees to settle for lees than what is owed.
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