Tag Archives: mortgage

subprime is still suspect


Subprime lending has been making a comeback.  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. Considering subprime borrowers will most likely want to refinance as soon as possible to get better terms on the loan, would prospective subprime borrowers be better off taking out the loan or waiting and rehabilitating their credit to become a prime borrower?

Assume that it is possible to go from subprime credit to prime credit in 2 years.  This assumption is convenient to use because of terms in subprime lending contracts, but it is reasonably realistic, assuming there are no bankruptcies or judgments in the borrowers recent history.  If there are, then the borrower’s ability to refinance out of the loan in a timely manner is questionable to begin with. 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%.  For this analysis I will include the requirement that the loan be held for 2 years.  This is not unreasonable; banks often require such a condition to ensure they get enough interest for the risk they are taking.  I will not include a prepayment penalty for simplicity, but for subprime loans, there will generally be a prepayment penalty. Calculations are done in nominal terms, as that is what the borrower would see on their statements.

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 at the 2-year mark.  The amortization schedule of a subprime loan with the above assumptions is in this Google doc.  For those that wish to play with it, the values at the top can be changed as inputs, but there must be a % symbol with the rates.  Assuming the house price stays the same, the schedule shows when various equity milestones, as well as credit rehab events would occur in the life of the sub prime loan.

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 can finally get out of the loan, but they have paid about $41,000 in interest, and only about $4,500 of the principal.  With the down payment, they have $13,600 + $4,500 = $18,100 in equity, or about 6.65% equity.  They have also spent the equivalent of $1,708 a month in interest.  While shorter loans would result in equity accumulating faster, it would also result in a much larger monthly payment. The results would only get worse if we included a prepayment penalty.

In order to refinance the loan, 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 have to appreciate to roughly $317,000, a return of 16.5% on the purchase price.  This is possible, but in a sense the subprime borrowers are speculating on the value of the house in two years, where the payoff is the ability to refinance your mortgage before it ruins you.

Contrasting that with a prudent alternative, a borrower that lived in a modest apartment with only $1,200 per month rent would accumulate an additional $12,000 to add to what ever else they had saved, resulting in a much larger down payment.  Assuming they rehabilitated their credit to prime, they get a much lower rate, and a more manageable monthly payment.

Many subprime borrowers cite the investment benefits of owning a home, tired of paying rent, they want to start building equity.  However, by taking on a subprime loan, they are gambling with their financial future with very little to gain.  Since so much of the early payments go to interest, the owners may end up paying more in interest then they would have in rent for the same period, and should they fail to refinance the loan, they will most likely lose thousands, if not the house entirely.

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 when they sign up for them.  They may find that patience could pay off.





Relaxed Borrowing

It no question that a big cause of the 2009 recession was the sub prime mortgages banks were practically giving away. After the collapse there was a lot of talk of moral hazard, and the banks playing fast and lose with everyone’s money. With the bailouts came tighter regulation, sub prime mortgages disappeared and it borrowing standards became tighter. Now almost five years later it appears that standards are beginning to lighten up.

Mortgage production has stalled, and aside for a quarter at 2011, is lower than its ever been since 2009. In response the banks have began to lower the borrowing standards. Is this the first step back down a slippery slope or are the banks regaining confidence in the market?

After an initial pass through of the article I believed that this was the start back down a slippery slope. The banks were making less money than used to and saw a way to profit by lowering borrowing standards. It seemed all to familiar, the banks trying to make more and more money by making riskier bets. It wasn’t a sub prime mortgage but it looked like the start of them returning. After the initial read I did some research on historic mortgage rates to see just how risky the banks were being.

To start I looked at the average credit scores for those new mortgages over the past ten years. As you can see from the chart below, scores below 620 were accepted at a rate of almost 10% around the collapse. After, it took about a minimum score of 640 to be accepted for a mortgage. No banks have a standard credit score when evaluating candidates, however it is unlikely that banks are going back to the 620 standard seen before.



Another piece of information for evaluating how stringent banks are being is the percent down payment they require on each loan. Down payments vary depending on other factors but after the housing collapse banks were requiring as much as 20% down on homes. In the past year rates have been dropping below 10% and some lenders are moving below 5%, with a good credit score that is. These numbers don’t seem very different than those in 2009 when the housing market collapsed.

So it may seem that banks are loosening their standards. However this isn’t something that is anywhere as risky as the sub prime mortgages of 2009. The banks are remaining stricter on the credit scores to ensure that the loans aren’t defaulted on. So with the banks lowering standards, it is likely a better sign of a strong economy over a moral hazardous financial industry.


Banks Begin Easing Mortgage Lending Standards

This year many large banks that have historically relied on mortgage banking have reported that there revenue from mortgage refinancing and origination has fallen significantly. Many banks are learning that the market for refinancing has dried up and originations are slowing too. The Mortgage Banker Association forecasted mortgage originations to fall 36% from $1.8 trillion to $1.1 trillion. According to Michael Fratantoni, Chief Economist of the Mortgage Banker Association, “with volume dropping as much as it has, many lenders are looking to expand their credit box,” in order to compete for the smaller fraction of originations (Mortgage Lenders Ease Rules).

For borrowers this means the lightening of credit restrictions and the reemergence of low percentage down payments. For the economy this will likely be good news. It is widely believed that the biggest deterrent for a speedy housing recovery was the restrictive lending standards imposed by banks. These standards prohibited many from participating in the housing recovery, thus slowing the recovery process. According to research done by the Urban Institute in Washington, if credit standards in 2012 had returned to pre-bubble levels, over 200,000 mortgages would have been originated that year. Furthermore, Goldman Sachs estimates that new home sales will rise 800,000 units in 2017 from 430,000 last year, but if lending standards are not eased they are forecasting that the increase will only be 600,000 units. (5 Questions on State of Mortgage Lending) According to this data, the lending restrictions are slowing the housing recovery by 33%.

As we learned in 2008, too lenient of standards will inevitably cause a credit bubble to develop. The changes that we are currently seeing in lending standards are not the same standards that caused the bubble to develop in the early 2000s. For example, many of the mortgage defaults prior to 2008 were a result of adjustable-rate mortgages that bated customers with short term teaser rates that rose shortly after and the origination of mortgages without income verification. Despite low cash payment mortgages reemerging, the mortgage products offered are more straight forward for the consumers as a result of new consumer protection legislation enacted in January. Also lenders have become stricter on verifying income and sources of down payments.

Overall, I believe that the easing of credit standards will be a good thing for the domestic housing recovery. It is unfortunate for the banks that it took large revenue declines for them to finally take more risk in their lending practices, but for the sake of the housing recovery this is a necessary step in order for housing to recovery to pre-recession levels.



Time to Buy?

Anyone with a basic understanding of the economy knows that now is a good time to buy a house. Mainly because interest rates and prices are low – and rising. The longer people wait, the more they will have to pay for their home. But there is a challenge to home-buyers right now: Wall Street investors looking to “Flip This House”. Big businesses are also taking advantage of low housing prices – and are capitalizing on their investments by buying cheap homes, renovating them, and selling them at a higher price. This isn’t bad for anyone, really, except for unlucky home buyers that are caught in bidding wars with these investors. Considering their hefty wallets, it is best for home buyers to simply back-off. So the competition to find houses is no longer a matter of outbidding someone else looking for a home – it’s now a matter of hoping that no big investors (who pay mostly in cash) notice your house. Despite this challenge to home buyers, though, now is still the time to buy.

In 2012, big investors bought about 140,000 houses in the United States (3% of sales). But this small percentage obscures the real impact on individual markets. For example, in July of 2012 corporate buyers accounted for 25% of house purchases in Atlanta, and 20% in Tampa. Though they are not investing all over the country, their concentration in real estate-desirable locations has a large impact in those particular areas. Other areas of concentration include Florida, Phoenix, Las Vegas and California’s Central Valley. Not only are these investors making it more difficult for home buyers, but they are also slowly driving up home prices.

Of course, this is something the economy wants. So comes in the need to purchase homes now.  A report from the National Association of Realtors shows that 5.1 million houses were sold in 2013, a 9.2% increase from 2012 and a 20% increase from 2011. In 2013, the median price of a house sold was $197,100 – an 11.4% increase from 2012. Increasing prices, lower unemployment, a decrease in foreclosures, an increase in demand, and low mortgage rates (though rising), have fueled the growth in the housing market.


The Home Price Index of the Federal Housing Finance Agency shows a 14% increase in home prices from 2012 to 2013. Though this is an excellent sign for the economy, it is a call-to-action for home-buyers. And not only because of prices: today’s 30-year fixed mortgage rates are far cheaper than they have been in 40 of the past 42 years (at 4.57% last week). But again, this rate is more than a percentage point higher than in January – mortgage rates are on the rise.

Thus, as we look at the recovering economy with positivity, we also see its impact on home-buyers. Although corporate investors are making it more difficult for some in real estate, there is no doubt that now is the time to buy.


Should We Be Too Cautious About The Housing Market This Year?

While the housing market has continued to gain its strength, many are still a little weary of what could happen in 2014. There are many factors that could create a small downfall in the housing market, but “rising home prices, low mortgage rates and ‘significant pent-up demand’ will boost the housing market this year.” Says NAHB Chief Economist David Crowe. Crowe also mentions the factors that could very well be holding back home construction itself saying that “The pace of the recovery could be stronger were it not for rising construction costs and inaccurate appraisals that are keeping some home sales from going through.”

A major factor we have seen with the housing market is with mortgage rates. Last summer when mortgage rates rose, the market lost a little steam power. With the fed cutting back its bond-buying program from $85 billion a month to $75 billion a month, there will be a bit of caution knowing that this decision will cause mortgage rates to rise. But with this choice the Fed has made, they believe it will help “the cumulative progress toward maximum employment and improvement in the outlook for labor market conditions,” the Federal Open Market Committee said.

As our economy has slowly grown out of the housing bubble bust a couple years ago, I believe we should not be too optimistic for 2014. The facts have shown that when mortgage rate rise, the housing market loses momentum. Currently, the average rate on a 30-year fixed mortgage is about 4.51%. Even though that rate is considered low, mortgage rates are sure to rise as the Fed gradually reduces its monthly bond purchases.  Lawrence Yun, a leading industry economist, “expects rates to rise a pointe by the end of this year to 5.5%. “The higher borrowing costs—coupled with rising home prices—are a concern because they could make homes less affordable for potential home buyers, ultimately hurting sales.” With higher construction costs being one factor, home builders have “lost confidence in all three components of the index: current sales conditions, future sales expectations, and traffic of prospective buyers.”

Over the next couple of months, I would expect the housing market to go down while mortgage rates rise. However, as we see mortgage rates rise, we should look for unemployment to go down. From this I believe that the overall effect of the Fed cutting its bond-buying will help the housing market. It may not be within the next 6 to 8 months, but towards the end of 2014 we should look for more of an upswing.