What are sub-prime loans?

In the 1960s and 70s, many lending institutions would use a process called redlining to deny loans. Redlining is using boundaries to determine who would qualify for a loan. Typically redlining prevented minority groups or people living in less desirable neighborhoods from owning a home. When this process became widely known, steps were taken to halt the practice. The mortgage industry was deregulated and a system was set in place to encourage those who previously could not buy a home to become homeowners.

This process was not without its faults, however. As the housing market heated up, lenders looked for ways to loan to those who technically should not be considered for loans. A sub-prime loan is the term used for loans that are risky than a traditional loan. A buyer may have a legitimate reason for needing a sub-prime loan, but for many, the sub-prime loan was a way to purchase a home that they really could not afford. Along with sub-prime loans came loosened restrictions on underwriting loans, and many no-down payment- no document loans were written. Buyers could qualify for a home loan with a credit score below 600.

A person in need of a sub-prime loan is considered a non-conforming buyer. Some reasons that a buyer may fit these qualifications are if they have a poor credit history, they cannot document their income, or they are buying an expensive home. Because federal loan amounts, backed by Freddie Mac or Fannie Mae, are limited to $417,000, any amount greater than this is considered a jumbo loan, and required special financing. Sub-prime loans traditionally have a higher delinquency rate.

What has happened to the real estate market?

Although it seems that everyone is losing their home, the situation is not that dire. Roughly 14% of sub-prime loans go delinquent. While this number is higher than traditional loans, it is still has an 86% repayment rate. Because sub-prime mortgages are aimed at those that would not qualify for a traditional loan, it stands to reason that the delinquency rate would be higher.

For sub-prime loans to work properly, the housing market must be relatively stable, and homes must continue to increase in value. When this does not happen, delinquencies increase. With an adjustable rate mortgage, which these sub-prime loans typically are, the monthly payment can increase dramatically. In the past, when these rates increased, the homeowner could refinance the home. However, with a stagnate housing market, the home may not appraise for the amount needed. When this happens, the owner cannot refinance, and they are stuck with the higher monthly mortgage payment.

It is interesting to note that 35% of the homes that are foreclosed in the sub-prime market are investment properties. These are typically second properties, purchased by the owner who hopes to fix the home up and "flip" it, or sell it quickly, ideally before the first payment is due. When the housing market quieted down, and these homes sat on the market, the owners were locked into not only their primary residence, but making mortgage payments on the investment property as well.

How does the mortgage crisis affect me?

Does the current mortgage crisis affect you? It may. Many people are in homes that are worth less than they owe. If you are in this situation, it would be impossible to refinance the home if needed. Additionally, living in a home that is worth less than you are currently paying, it means that you have no equity in the home. If you needed some quick money, you would not be able to tap into a home equity line of credit, and your home, no matter how nice, is not technically considered an asset.

Another way that the current state of the mortgage industry affects all of us is through home values. It is a circular problem. As more people cannot afford their mortgages, they are forced to enter into short sales with their lenders. A short sale is a sale where the new buyer pays less than the amount owed on the loan. When the home is involved in a short sale, the buyer gets the home for less than market value. The home's selling price is recorded, lowering the property values in the neighborhood.

How can you prevent getting embroiled in the mortgage crisis? While most agree that this is a cycle, and home prices will rebound, what no one knows is how long that rebound will take and if the housing market will reach its previous high levels. For those that bought "at the top" of the market, it may be quite a while before they have any appreciable equity in their home. If you are currently a homeowner, or are considering buying a home, there are several ways that you can reduce your risk of financial hardship with your mortgage. Maintain a solid income, living beneath your means. Accumulate other assets, in addition to your home, and if you know that you do not have any equity in your home it is doubly important to build up a financial safety cushion in a savings account.

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About Author: Brain Jenkins is a freelance writer who writes about topics pertaining to the mortgage industry such as a Pennsylvania Mortgage