Wednesday, October 15, 2008

Flashback: The subprime mess and mortgages

With mortgage rates climbing to 6.47% from 5.99% today (yeah, essentially half a percentage point!), now is as good a time as ever to open the vault and re-post an important article I wrote back in early July on "A Brief History of the Subprime Mess and Mortgages." Enjoy!

I was recently asked what "this whole subprime thing" is all about. It dawned on me as I was telling a truncated version of the debacle that if more people knew just a bit more about mortgages before buying their now-foreclosed homes, this whole credit meltdown might have been avoided. (Blame also goes to the banks, for okaying people who were unqualified to take on such large loans, but that's beside the point.)

And so, before I delve into the mysterious world of mortgages, here's a brief history of the subprime mess, in 30 seconds or less:

It all began in the heyday of the early 2000s, when RAZR flip phones were the latest high tech gadgets, Britney was beginning her descent into the maelstrom and 9/11 reminded many that safety was an illusion. During this time, swarms of Americans took advantage of broker-approved "easy" mortgages that lacked the stringent requirements of mortgages of yore. People banked on the hope that future job raises would occur to cushion monthly mortgage payments and U.S. employment rates would continue to prosper.

But as we all know, when it comes to matters of money, banking on faith and hope alone is never enough! You know how credit card companies try to rope you in with deals screaming "0% APR for 6 months!*" and after closer inspection of the asterisk, you see after six months that your APR balloons up to 19% per month? Well the same kind of thing happened with many mortgages. Lower initial interest rates began to soar while unemployment began to unexpectedly rise. People began to default on their loans, either by losing their jobs or lacking sufficient income, and banks began to repossess homes, which resulted in mass foreclosures across the country.

Say you're paying $1,200 per month on your mortgage, and spending instead of (ahem!) saving on new cars or giant HD flat-screen TVs -- hey, you own a home, you need to buy stuff to go with it, right? Life is good till you realize that you are among a bunch of people who are going to be laid off at work. Now add to that a ballooning mortgage interest rate that you were planning to pay off with some fantasy future raise, and credit cards that you maxed out from overspending. Oh, and guess what? By 2005, house values are in a nosedive and your home is worth drastically less than you bought it for.

This is where a resounding "Crap!" was heard across America. With no savings built up, you've dug yourself into a hole so deep not even Beatrix Kiddo (a la Kill Bill) could climb out of. The debt dominoes fell, leaving a trail of woe across the country, and there you have it -- the 30-second history of the subprime mess. Phew!

Now that you're a subprime guru, your first lesson in Investing 101, or what I like to call "I want to buy a home but I know nothing about the process," is mortgages, or the heart of darkness within the bizarre world of investment banks, credit ratings and foreclosures.

A mortgage is type of loan that is specifically used to buy property (aka a house!). The house you buy with said mortgage is used as a collateral, or guarantee, for the amount you've borrowed against it. Don't have a dime to your name but still have $150,000 left on your mortgage? Then your house will be taken from you to repay off the existing debt on it.

There are a myriad of mortgages out there, but the most common are:
  • Fixed-rate mortgages -- Or loans where the interest rate is fixed for the entire term of the mortgage (usually 15 or 30 years). This is my favorite type of loan, it's steady and less risk-adverse then its brethren.
  • Balloon mortgages -- Loans where the interest rate is set for a given amount of time and then the entire payment of the loan is due at the end of that time.
  • Adjustable-rate mortgages (ARMs) - Loans where the interest rate can change and fluctuate as the prime or standard rate (set by the Federal Reserve) changes. (This is very risky since you can't be 100% sure which way a rate will go.)
  • Interest-only mortgages -- Loans where the interest only (hence the name) has to be paid off in the beginning, resulting in a very low initial monthly payment that hinges on the hope that property values will keep rising. Still with me? By using this loan, many people could buy larger homes they wouldn't have been able to afford otherwise. When home values tanked, they defaulted because their houses were worth much less than their loan price. Home owners couldn't grow equity over the time they invested in the house.

Just by looking at these four common mortgage choices, you can quickly see which ones -- balloon mortgages, ARMs and interest-only -- might have fabulous initial perks, but are the riskiest and were the culprits in "this whole subprime thing." It's marvelously simple, isn't it? And you don't even need a suit and a finance degree to understand it!

You generally get a mortgage by divvying up a down payment, which is usually between 5% to 20% of the loan total. See how this whole "saving" phenomenon I keep raving about comes in handy? Remember, chickadees, the larger the down payment, the more you win because of the decreased amount of interest you have to pay overall. It's just like paying off a credit card bill with much more than just the minimum payments, so you don't get stuck in the endless cycle of paying off interest on the money you borrowed. And the cherry on this ice cream sundae of down payments? If you put down 20% or more on the loan, you're given a "get out of jail free" card of sorts to not have to carry mortgage insurance, which saves you tons of money. (I knew those long games of Monopoly came in handy for something!)

So you see, now, why saving is so very important. When the debt collectors come a-knockin' and you've just gotten notice you're "not needed anymore" at work come Monday ("the company thanks you for your loyal service over the last decade," though), you'll be happy you were insightful enough to sock away savings and plan for all of life's little catastrophes, subprime or not!

2 comments:

FruGal said...

Down payment, down payment, down payment!!! I don't know how many times I day I write about the importance of having a substantial down payment, but it's a lot! If the only thing that comes out of this whole mess is that people go back to understanding the importance of saving a big deposit before committing to a mortgage, that - at least - will be a good thing. Even during the heady heights of the cheap credit of the past ten years, I never would have considered buying a home with a 100% mortgage - and it still shocks me how many people thought this was a good idea. We need to go back to saving before buying rather than buy now pay later.

Your site is great. I've just discovered it and am defo going to keep reading along.

Crystal said...

Hey frugal! Yes, it's ALL about the downpayment. The whole "buying now, paying off" later thing was never and will never be a good idea.

Thanks so much for reading! :)

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