The housing market has seen a rise in subprime lending recently. As banks slowly returned to the market, they offered harsh terms involving large down payments (25% or more) and charged rates between 8-10%. As reported in the Wall Street Journal, the down payment requirements have recently been dropped to 5% of the loan. The individuals in the article that took the loans gave reasons such as “I wouldn’t have been able to get the place I wanted without this” and being “ priced out” of the market if they waited. By analyzing subprime mortgages more closely, we can get a better idea of the assumptions these buyers are making.
Assume that it is possible to repair a borrowers credit in 2 years. This is reasonable, assuming there are no bankruptcies or judgments in the borrowers recent history. Using the average housing price of $272,000, I assume a subprime borrower would have a down payment of 5%, or 13,600, and that they borrow at 8%. Assume that the loan will be refinanced no sooner then 2 years; banks often require such a condition on subprime loans to ensure they get enough interest for the risk they are taking. I will not include a prepayment penalty for simplicity, but there will generally be a prepayment penalty.
Whether the subprime loan is better comes down to whether or not the buyer can accumulate enough equity to refinance the home out of the subprime loan and into a prime loan as soon as possible. The amortization schedule of a subprime loan with the above assumptions is in this Google doc. Assuming the house price stays the same, the schedule shows when various equity milestones occur.
Assuming that the loan is for 30 years, the subprime borrower would have a monthly payment of almost $1,900, yet all but $173 of the initial payment goes to interest, assuming it is not an interest only loan. By month 24, the borrower has paid about $41,000 in interest equivalent to $1,708 a month. With all that interest, they have only paid about $4,500 on the principal. With the down payment, they now have $13,600+$4,500= $18,100 or about 6.65% equity. The situation could be even worse if any of the payments where interest only.
In order to refinance, the owner needs to have equity in the house, typically around 20%. Since the borrower isn’t going to have anywhere near that amount of equity, the house would also have to appreciate to roughly $317,000, a return of 16.5% on the purchase price. To put this in perspective, the highest growth rate over two years in the national composite home price index was 29.5%, between Q1 2004 and Q1 2006. Whether 16.5% is a reasonable assumption is up to the borrower, but in a sense the subprime borrower is speculating on the value of the house in two years, where the payoff is the ability to refinance their mortgage before it ruins them.
Many subprime borrowers cite the investment benefits of owning a home. They are tired of paying rent, and want to start building equity. However, by taking on a subprime loan, they are gambling with their financial future for very little payoff. Since so much of the early payments go to interest, the owners may end up paying more in interest then they may have in rent for the same period. More over, should they fail to refinance the loan, they will most likely lose thousands, if not the house. The analysis presented here shows some of the math that needs to be done by subprime borrowers. Subprime loans are not inherently bad, but borrowers need to understand the assumptions they are making about the value of their home in the future, their ability to refinance. The gains may not be worth the cost.