A bumpy road for the mortgage market

The subprime shakeout means some changes for homeowners and those looking to buy a home, especially if you have poor credit.

By Bridget Smith

There’s a shakeout going on right now in the subprime mortgage market. What does that mean to you, the average home owner? What if you’re getting ready to buy your first home? What if you don’t even know what subprime means? Do you need to know? Should you care?

More loans going bad; foreclosures up
First, a recap of what’s going on. Over the past few years, interest rates fell to historic lows, meaning that the cost to borrow money to buy a home became really cheap. At the same time, new loan options became available, and many lenders loosened their borrowing standards to expand home affordability. This created a housing boom that allowed folks who in the past couldn’t buy a home – either because of a spotty credit history or lack of a down payment – to become homeowners.

Problems arose when interest rates started rising. Some buyers had bought homes with loans that featured low introductory teaser rates. Based on their income, they could afford these initial low mortgage payments, but when their initial rates expired and their interest rates increased to normal levels, many were faced with drastic payment increases. In some areas of the country, homeowners who put down little or no money are facing higher payments and aren’t able to refinance, because falling home prices mean they now owe more on their mortgage than their home is worth. Many buyers are falling behind on payments and their loans are going bad. A lot of folks who stretched are now losing their homes.

Freddie Mac gets involved
In February, Freddie Mac (a quasi-government agency that provides funding to lenders) decided it needed to set tougher lending standards to reduce the risk of borrowers defaulting. Starting Sept. 1, the only subprime adjustable rate mortgages Freddie Mac will buy from lenders are loans that qualify buyers at the fully indexed and fully amortizing rate, rather than a low, introductory rate that may last only 6 months or a year.

The goal is to protect borrowers from the kind of payment shock that helped create the current mortgage situation. (Subprime simply means borrowers who have poor credit histories.) In addition to those changes, Freddie Mac also said it will limit no-documentation mortgages (mortgages in which borrowers do not have to document, or prove, their income) to ensure borrowers truly can afford their mortgage payments.

What it means to you
So what if people you don’t know are defaulting on their loans? Why would that matter to you?

Home buyers
The changes in lending standards affect future home buyers, because loan standards are changing. If you are considering buying a home in the near future:

• A substantial down payment and good credit will most likely be required.
• You will likely be required to document your income and your assets (and your co-borrower’s, if you have one), unless you have a very strong credit history.
• It may be more difficult to find flexible payment mortgages, where you have a choice of payments each month, unless you have a very strong credit history and your income can cover the highest payment.
• It’s always a risk to stretch to buy a home, but in the current environment, buy a home you can comfortably afford.

Current homeowners
Most homeowners don’t have to worry about the current mortgage mess, especially if you have a fixed-rate mortgage and good credit.

However, if you have an adjustable rate mortgage that’s set to adjust this year, you could be affected.

• If you have good credit and a fair amount of equity in your home, you should be able to refinance if your ARM payment jumps significantly, Refinancing to a fixed-rate loan with a competitive interest rate should help keep your payments affordable.
• If you have fair or poor credit and you’re facing a big increase in your mortgage payment, refinancing may be difficult. If you can’t afford higher payments, selling and moving to a less expensive home may help, as long as you can comfortably afford the payments and you can find a lender who will extend you credit.
• If your home has fallen in value since you bought it and you have little, if any equity, you may not be able to refinance to avoid a payment increase, because your loan amount is more than your home is worth. Your best option is to pay the higher payment and wait to build equity. However, if you can’t afford the higher payments, you should call your lender immediately to try to work out a payment schedule that you can afford. Other options are a short sale and foreclosure, neither of which are good options.

Takeaways for everyone

• Save! There are risks to homeownership, and having a savings cushion can help if trouble arises. Many homeowners got into trouble by dipping too far into their home equity, only to see their home values fall. Open a savings account and start socking away money so you don’t get stuck in that situation.
• Clean up your credit. Consumers with good credit pay less to borrow money. If you can’t pay your bills, you’re spending too much. Cut up your credit cards and figure out how to get out of debt.
• Don’t buy more home than you can afford. It’s easy to fall in love with a house and stretch to buy it – I know because my husband and I just went through the buying process. Don’t even look at houses out of your price range, and stick to a traditional 30-year-fixed mortgage.

Homeownership is a big commitment. Rather than getting a loan you don’t really understand, step back, research your options, and save your money a few months longer or get your credit in shape. In the long run, you’ll be happy you’re in a home you can afford, rather than in the poor house.

Related Topics:

• A Borrower's Tale
• Mortgage News
• The Smart Borrower Update