Subprime Mortgage Lending – What Are Its Effects?

Subprime lending is really nothing new. It was originally designed to enable people with less-than-sterling FICO scores to purchase homes, cars, and other items for which they couldn’t get conventional loans. Also known as “second chance” lending, its purpose was to provide responsible individuals with a second chance to become homeowners.

In the mid-1990s, with real estate values continuing to climb, subprime lending became very popular. Unfortunately, many of the people who got involved with subprime lending were not really responsible, or did not fully understand what they were getting into. Some of them interpreted subprime lending as a means of buying a house without a down payment; others saw it as a means for entering a real estate market that was changing very rapidly. Subprime lending was never intended for these purposes.

You can see the effects of misuse of subprime lending in real estate markets all over the United States. For example, people who have bought homes during the last few years using subprime lending usually have not been able to provide a down payment of 20% on their purchase. Private mortgage insurance (PMI) is required in such cases. Private mortgage insurance is available at additional cost to the buyer, above and beyond the required homeowners insurance. With PMI, the lender has a guarantee that if the buyer defaults on the loan, the mortgage amount will be repaid to the lender. The cost of PMI is now deductible from the buyer’s income tax!

Defaults on subprime loans are becoming more and more common. One reason for this increase in defaults is that, lulled by the ready availability of subprime lending, many people have purchased homes they really cannot afford. Some of these are carrying adjustable rate mortgages (ARMs), which are readjusted every couple of years – always upward. In past years, someone who was interested in an ARM needed to qualify not only for the initial rate, but also for two subsequent upward rate adjustments.

In recent years, this has not been true. These ARMs have been offered at extremely low introductory “teaser rates,” and those who qualified for the introductory rates were not required to qualify for subsequently adjusted rates. Rates have gone up by several percentage points. Mortgage rates for many people have nearly doubled. In combination with the record high cost of gas and oil, along with steadily rising prices for food and commuting by public transportation, this means that large numbers of families are unable to continue to pay on their subprime mortgages.

Another effect of easily-available subprime loans is that many people who knew nothing about real estate or property management decided to buy real estate. One reason real estate prices were driven to levels that were both unrealistic and unsustainable is that “flipping” properties had become common. This means that people were purchasing real estate, “fixing it up” a bit, and then reselling it for a very good profit. In time, these artificially high “bubbles” burst. Prices fell suddenly and dramatically, and these inexperienced individuals found themselves with property they had bought with the intention of reselling quickly — and with no buyers.

The value of many of those properties is less than the amount owed on them. Foreclosures are rampant. Foreclosure sales in a particular neighborhood reduce property values in that neighborhood still more. This kind of cycle is not easy to break.

Subprime lending, then, can be an excellent way to provide a second chance to restore credit and to purchase a home. On the other hand, its effects can be very dangerous if they encourage inexperienced individuals to jump into a rapidly-changing real estate market. Be sure you understand the expected effects before you take any action involving subprime lending!

Jane A. Smith

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