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How subprime mortgages work

The Washington Post has an infographic that explains how the subprime mortgage industry works, but it doesn’t explain why it’s failing right now. It worked fine as long as the people who subprime mortgages were being sold to could keep making their mortgage payments, but suddenly many of those customers are getting behind. The real driver in this industry has been selling people houses they can’t afford through the use of tricky mortgages with low monthly payments and no money down. Common forms include interest only mortgages, where you don’t pay any of the principle of the mortgage, or payment option mortgages where you don’t even pay all of your interest every month, and the part you don’t pay gets added to the principle of the loan. That’s how people with modest incomes have been able to buy homes in overheated markets in places like Los Angeles.

The catch with payment option loans is that once you get far enough behind, the bank raises your interest rate and starts demanding very high payments. You can’t keep growing the principle on your loan forever. Homeowners in this situation had been saved by appreciation. They made their payments for a couple of years, and then refinanced, using the equity gained through appreciation to cover the interest and principle they hadn’t been paying. When homes stopped appreciating enough to save these people, the bottom fell out and killed the entire subprime sector.

Now, with the number of foreclosures going up and the pool of possible home buyers shrinking to people who can prove they can afford a traditional mortgage, it sure doesn’t look like recovery is right around the corner for the real estate market.

In other news, Countrywide has stopped offering no money down mortgages. Stated income loans (where the mortgage company takes you at your word on your income rather than demanding documentation) are also on the way out. It turns out that these were opportunities for fraud:

Three months later, Mapula, whose take-home pay was $3,400 a month, and Plata, a homemaker and mother of two, bought a half-million dollar home on Burdick Way, paying only a $5,000 escrow deposit. Originally from Sonora, Mexico, Mapula moved to San Jose six years ago.

Mapula qualified for the loans through a stated-income process, which offers less-rigorous verification of income than conventional loans, his attorney said. Though Mapula signed the loan application that was submitted to Long Beach Mortgage, his lawsuit says he learned later that it falsely claimed he was making almost $100,000 a year from two jobs and receiving an additional $16,800 a year in rental income. The application also said he had $19,700 in the bank, owned a $22,000 Acura and had $28,000 in furniture and personal property. Mapula said none of that was correct.

It’ll be interesting (and probably depressing) to see what happens next.

2 Comments

  1. I’ve been obsessed with the ‘housing bubble’ for a couple of years now. You correctly summarize the situation in the ‘hot’ markets.

    What amazes me is that lenders have also been handing out these types of loans to low-end homes in markets that aren’t appreciating much (like the suburbs of Austin, where I live). The people who take these loans don’t have any realistic options for refinancing or selling at a higher price when their monthly payment goes up a few years into the loan.

    The theory is that these buyers will have a higher income by the time their payment increases, but I’m skeptical of how often this works in practice. Of course, I’m skeptical of the whole situation.

  2. Today with the high cost of living,increased medical costs and in many cases families commune like living arrangements it seems to me someone should look into the possibility of developing a loan to serve this market.

    It seems something could said for quaiifing all members and combining their incomes of all of the occupants involved involved would enable the group to purchase something suitable for their needs as well as offering the lender a broader security base.

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