The media has devoted a lot of attention to the subprime mortgage market and its credit crunch as a rising number of homes find themselves in foreclosure or nearing foreclosure. And there has been a lot of speculation as to what this will mean for the future of real estate and real estate investing, but to understand what may come of the crisis one first needs to understand the crisis and its underlying causes. So what is the subprime market and what is the credit crisis all about?
Simply put, a subprime mortgage is a loan for those who would not qualify for “prime” lending rates, which are commonly the average lending rates. The people that typically are included are those whose credit factors include a low income, inability to provide full documentation to meet the expectations of prime lenders, and most commonly those people whose credit scores are lower than prime lenders consider acceptable. Often this credit score is one below the 650 mark on a FICO credit score. Historically the score of 650 has been a minimum bar for home owners, with 95% of homeowners having scores above this score and thus being eligible for “prime” rates, but in recent years the subprime market grew from just 5% to 15% in a matter of a few years.
Typically these subprime borrowers are considered by the bank to be at a higher risk of defaulting on their loan, and in turn lenders charge higher interest rates for these borrowers. The higher payout for the lenders, cradled with rapidly rising home values created an environment that seemingly was a perfect investment opportunity. Many lenders seized the opportunity to charge higher interest rates on property, assuming that if the loan was defaulted on, the property would have very likely risen in value. To attract subprime borrowers and create an opportunity for them to enter the market many lenders introduced “adjustable rate mortgages” or ARMS. These “honeymoon” loans often started with a introductory period of two to three years that offered a very low interest rates, and many times the lender required the homeowner to put little to no money down on the property. However, after this introductory period of time these adjustable rate mortgages dramatically rose their interest rates to two or even three times their initial rates.
Many homeowners assumed correctly that their rates would dramatically increase, but they also assumed incorrectly that since their property value would have increased during the honeymoon period that the increased value of their home coupled with the equity they had put into their home would allow them to refinance with another lender at the “prime” rates, or at least another introductory rate. When the lending institutions found themselves with a mounting number of delinquent subprime borrowers as rates rose, and it became apparent that too many peoples’ credit has been over extended. Defaults skyrocketed, and the number of lenders willing to refinance a “high risk” loan dropped dramatically, making it harder and harder for subprime borrowers to refinance their loans causing them to add their property to the foreclosure market. This downward spiraling cycle has caused an increased number of foreclosed homes on the market, which in turn dropping home values and eliminated the short-term investment speculation that banks had been using as a safety net.
To combat this downward spiral and cycle of foreclosures, the U.S. Federal Reserve has cut interest rates several times trying to entice lenders to loan more money. And their has been numerous reforms and bills in committee to help reduce the prevalence of predatory loan practices, as well as to help the millions of homeowners that are finding themselves in the middle of the credit crunch. What this means for the short-term future of the real estate market is up for speculation, but most investors agree that in the long-term real estate will rebound and regain its reputation for being a great investment.