Wednesday, December 19, 2007

Sub-prime fiasco

Part of me isn't surprised about the current sub-prime mortgage fiasco. Combine people living beyond their means, i.e., spending more than they make, and greedy lenders and you have a formula for disaster. The current situation is a bit reminiscent of when we purchased our first house and mortgage rates were between 18-21%! To try and get people to qualify for mortgages they wouldn't otherwise qualify for, lenders were offering GPMs (pronounced gyp-em as that's what they were) or Graduate Payment Mortgages. The theory was that you payed less than the interest due during the early parts of the mortgage. The result was that as time went by, you owed more money than when you started.

Although GPMs weren't the same as ARMs (adjustable rate mortgages) they shared many of the same pitfalls. It may have been possible to combine them, although I can't remember for sure, to guarantee that the mortgage you barely qualified for wouldn't be something you could afford in a couple of years. The problem with ARMs is that they almost ALWAYS go up in rate a lot during their first adjustment period or two. What that means to a borrower is that a $150,000 mortgage with an initial interest rate of 4% yields a $716/mo payment, plus taxes, homeowners insurance, and mortgage insurance, making the payment more like $1000/mo or more. But that teaser rate is often only good for a year or two and was bought down substantially by the borrower paying points (prepaid interest). After a year or two, the rate climbs to 6% and then again a year or two later to maybe 8%. That increases the monthly payment from $1000 to nearly $1200 and then almost $1400. Suddenly what was barely affordable at $1000/mo becomes impossible to afford at $1400/mo.

You combine the above with modest to non-existent wage increases and flat housing prices and new homeowners are likely to lose their shirts (as well as their homes, their credit, and their down payment). The problem has apparently been exacerbated in some states like Illinois where less than scrupulous lenders altered applications to allow applicants to receive mortgages they weren't qualified for.

The moral of the story? Live within your means and don't fall for some teaser rate a mortgage broker or real estate agent tries to convince you to accept.