It's stupid to be talking about foreclosures when something could have been done to prevent it before the loan was obtained! All of a sudden everyone cares! It is interesting that during the last few years no one in real estate cared to talk about the types of loans that many home buyers were using. I learned a long time ago that it isn't wise to drive a car foreward by looking in the rear view mirror only. No one cared to ask if this was a wise at all, or even commented that it may be financial suicide. It is funny now that real estate in flux, everyone is commenting about it! You cannot avoid reading about it or hearing about it all day long. It is the topic on Wall Street, stocks, home sales, foreclosures, investments and mortgage company failures! There is talk on the newlines about the need of Government bailouts in the forms of the Federal Reserve dropping the discount rate, and more. Some heavy duty stuff here. Where were the calls of caution when it was taking place? How come no one cared then when marginal buyers showed up in busloads for risky loans without any of their own money,,,it was OK then? I mean anyone knows that an Interest only loans is pure risk! I remember in school learning about the 30 year fixed rate loan with Principle Interest Tax and Insurance PITI. It was really created after the Great Depression to prevent a repeat of foreclosures of the Interest only loans so common just a decade before throughout the 1920's. The difference then was the mortgage borrower had to put down at least 30% unlike nothing today.
An Amortized 30 year mortgages is also referred to as a "budgeted loan!" It allows the borrower to repay the borrowed princliple in a simple amortized mortgage. It provides for the payment of Interest on the outstanding principle, and allow the accumulation on a 12 month basis an escrow of tax and insurance. At the end of the 1 year accumulation of taxes and insurance...there will be money aside for the annual taxes to be paid in full, and the funds will be disbursed for the annual Insurance premium. In this sense , a thirty 30 fixed rate amortized mortgage is a very smart loan. It has a built in mechanism to pay taxes (so there is no defulat and seisure of the property if the tax bill is not paid, and if some destruction befalls the property that the lender is covered by an insurance policy. The fixed amortized loan was also smart as it allowed for a stability and predictability of payment.) (Unlike periodic adjustments in Adjustible Rate Mortgages and the pay in full principle demands of an Interest only loan.)
So the payments of a 30 year fixed rate mortgage in theory are identicle and predictable for the 360 payments This is why there were ceated! They were designed to replace the interest only mortgage. There was a time where the reasonably priced fixed rate loan was always the product of choice for consumers. (An interest loan pays interest only for the full life of the loan, never really touching the principle during the life of the loan which is around 5-10 years) When the pre-determined term period is over, the principle must be paid in full or refinanced again. The problem arises in our current market is that with teaser rates on sub-prime and Alt-A loans is that the borrower does not qualify to refinance their own loans, and in some cases the value has declined, and since these are now 100% financed loans the scenario is compounded with a negative equity position. It really makes you stop and think "What was everyone thinking in the last few years?
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Jim,
I have a interest only loan for the first ten years which then becomes a fully amortized loan for the remaining balance for the last 20 years.
It allows me to make principle reduction payments throughout the first ten years. I have been paying about $200 extra every month. At some point I intend to kick that up to a $1000 extra . Should work out pretty good as we have an appreciating market of about 10% per year here.
Gary your brought up a very interesting subject. Other than the 30 year amortized fixed rate loan, every other loan is great in a rising market. That is, as long as there is a rising home values or decent home appreciation... you are ahead of the curve with those products. If the markets are flat then the 30 year fixed rates amortized loan is the better bet with predictable payments. The other products take a bigger hit if prices fall. That is not a good position to be in.
The other item that may double compound the issue is that many of the folks that qualified for more borrowing power under the ARMS will feel the pinch of adjustments more as the market slides backwards. They are stretched to the max begin with.
Jim,
I agree with you. I know those loans were intended for people with growing incomes that need a way to just get into something. The sad part is that I really believe many people were not properly explained all of the terms of the loan.
Jim - good post. It is easy to get caught up in it all!
Tina for some people there are perfect. I know persons that live very conservativley and have loads of cash they like to invest. For them it is a smart thing, for others...not so smart.
Dawn I agree.
I was getting ready to post a slightly contrarian view when I read your last response regarding how these types of loans can be a smart thing. Whew. I feel better now.
I agree TOTALLY many of the loan products out there are just wrong, wrong, wrong for a lot of people, but the problem is not the loan, it's who is using it and why. 100% loans, as well as interest only loans, are excellent tools when used properly. Money put into a house as a down payment is not earning anything while the cost of borrowing money is tax deductible. To me, it makes much more sense to park funds in mutual or stock funds or even money market accounts, rather than having it "sit" as a down payment, not generating any income. With all that said, clearly, with that strategy, the money still exists.
Where the market went awry was making these loans available to everyone and failing to properly analyze the risk; the very people who should be utilitizing these products seem to lean toward more conservative products and the people who should NOT be using these products are the very ones who are using them, for all the WRONG reasons.
BTW, until 2003, we lived in your neck of the woods...up in Cherokee County, in Woodmont. ;-)
Enjoy your blog!
Susan the Interest only loans they are using are very similar to the 1920's the difference then was 20-30% down from what I've read... it is kind of scary when you think of no money down plus 100% loan...WAY SCARY! Like I said earlier it may be fine for some, but not everyone!
Lisa I totally agree pure greed...what has everyone concerned is "Now that I was a bad ...what's going to happen to me?"
As I have said before, lethal combination:
Stated Income, 100% Loan, Adjustable Rate
DANGER: Do not attempt in a declining market!
Jim, how interesting. You exactly precisely said everything and in the precise order it needed to be said.
While other bloggers on Active Rain have tried to build a case for never having any cash equity in your home, you and I have been around long enough to know what grief that scenario eventually causes, and we learned our economics from the same "school."
If a person hasn't had the discipline or good fortune to save enough money to comfortably invest a reasonable equity amount in his home, he has no business buying a home, we have no business encouraging him to buy one, and the mortgage lender who will loan to him chances spending eternity somewhere other than the Promised Land.
Congratulations for a job well done.
Jim
I found this post very interesting as here in the UK we are facing similar problems, albeit 6-12 months behind the US. As always it comes down to lax lending on the part of the banks which creates the boom and bust that is the economic cycle - we just have to live with the system!
The following scenario may be familiar to you:-
http://www.bbc.co.uk/blogs/thereporters/robertpeston/2007/09/mervyn_spanks_banks_1.html#commentsanchor
Many people believed that the UK would be immune from the problems you are currently experiencing - on Monday the first UK mortgage company went into administration and the cost of mortgages is set to rise because banks are re-assessing risk.
Jim,
I recently took a job in Hawaii, where the average home price was $670K, ao I could have either rented or bought using a interest only (10 years) for 80% of the home cost, with a 5% down and smaller loan for 15%.
For ease, please assume I bought a $1M home with $50K down, a $150K loan and $800K interest only. There is a three year penalty on the interest only loan. I paid the small ($150K) loan off in the first year seven months.
My question is: Is there a smart strategy for me for the interest only loan?
In all likelihood I will be moving from Hawaii before the end of the ten year period on the interest only loan. Hawaii market has traditionally been a 5 - 10% growth and seems to be close to that now.
Thanks,
Bill
Jim,
People really got careless with their budgets a few years ago. Basically what caused them do that was the continuous appreciation of their home values. As long as that was going on, there was little need to worry. But market economy can turn on you in a jiffy, as it did, and now they are paying for the carelessness. Good blog.