Now once upon a time the rule of thumb was that the monthly payment for a family should not exceed 25% of family monthly income. So that $200,000 loan should be supported by income of $7500 per month or $90,000 per year.
To qualify for the loan you needed 20% cash down, or in this case, $50,000. If you didn't have it, but had say $25,000 and excellent credit they would loan you the $225,000 but would charge you mortgage insurance until you could show that the payments and appreciation had now established your equity value of 80% of the loan value. At that point they would remove the PMI, but would also stress that you should leave the payment alone. To build equity. The truth being, of course, that they aren't concerned for the borrower, but since they wanted to bundle the mortgage and resell it, the more equity, the better the deal.
Now over the years the monthly income to loan payment percentage has became smaller and smaller, the price of housing became higher and higher and credit for ALL purchases became easier and easier and guess what... the number of qualified fixed "best" rate borrowers became less and less..... Enter the subprime.
A loan that is offered at a rate above prime to individuals who do not qualify for prime rate loans.
Subprime loans tend to have a rate that is 0.1% to 0.6% higher than the prime rate. Although the additional percentage may seem small, for mortgages and other large loans, this translates to thousands of dollars worth of additional interest payments.
And while I am not a genius, it seems obvious to me that if you can't qualify for a conventional loan of say, 5%, how can you qualify for a loan of 5.6%??
Subprime lending (also known as B-paper, near-prime, or second chance lending) is the practice of making loans to borrowers who do not qualify for the best market interest rates because of their deficient credit history. The phrase also refers to banknotes taken on property that cannot be sold on the primary market, including loans on certain types of investment properties and certain types of self-employed individuals.
Now while the emphasis has been on poor credit, the real culprit was average credit. The bills had been paid pretty much on time, the individuals had a good employment record… Comes the stretch. Only instead of stretching, we now have a Adjustable Rate Mortgage – ARM available for say, 3%. Sounds great. The payment is now in the $1200 range…. Principle, interest and taxes. But life is a beach and then you die….. That ARM is adjusted up 2% and the payment is back at $1600… in the meantime other debt has increased due to the spending on goodies for the new home, etc…. so now it has become a real stretch…. Toss in a 30% increase in energy costs, higher property taxes, higher insurance and the stretch has become a gasp. Then the ARM is bumped another 2% and the monthly is now around $1800… and the gasp becomes a scream. Toss in some loss of income…. No overtime say…. And the patient is terminal…
Now I’m not a forgiving type. These folks who over spent and exercised no restraint should pay for their mistakes. The problem is, the poison they’re taking is working its way up the food chain and getting to me. My portfolio has taken a 10% hit and I can’t really see the bottom. Especially since the market dropped another 60 or so points after hearing W’s plan. It is obviously not enough.
Why? Because those bad loans were bundled by the original bank and sold to another financial firm as an investment…. Let’s say that a bundle was sold for a million bucks… as the default rate goes up, more houses are foreclosed and put on the market… but the new price is less than owed, so the bundle is essentially of no value….or greatly reduced value…
Stay tuned folks. The aircraft has departed, but I don’t think anyone knows where it will land.