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Will Sub-Prime Lending Affect You?

With mortgage defaults on the rise here's what can buyers expect.
© Michael Cook
http://mortgagesloans.suite101.com/article.cfm/will_subprime_lending_affect_you

Mar 22, 2007
The real estate market has slowed significantly over the past year. Sub-prime mortgage defaults have been an early casuality of the bursting of the real estate bubble.
Sub-prime lending has exploded. With mortgage companies filing for bankruptcy almost daily, this situation has truly become dire. Many buyers and sellers are now wondering how this will affect their mortgages and property values. Unless you live in a few areas in California, there will be no affect at all.

What is Sub-prime Lending?

Higher interest rate loans made to less credit worthy tenants make up the sub-prime lending market. These loans could be 100% financed or slightly less, posing serious risk to mortgage companies in the event of default. Sub-prime lending has been around for quite sometime; however, during the real estate run up over the past five years, it's popularity swelled.

On the positive side many buyers, who would never have had the opportunity to own their own home, were able to obtain financing. These loans have contributed to the current record homeownership numbers across the United States. Additionally, many banks were able to be more lenient because of the aggressive appreciation occurring earlier this millennium. These loans naturally have a higher default rate, but the higher interest rates banks charge typically compensate for this higher risk.

What happened to the Sub-prime Lending Market?

The problem with the sub-prime lending market has been twofold. First, the slow down in appreciation has given buyers more incentive to default on their loans. With very little equity in a home, buyers that are strapped for cash are more likely to default on their loans. Additionally, these buyers are less creditworthy for a reason. Their history of default typically means they have more debt and/or less stable income. As the economy takes a negative turn these homeowners are likely to be affect negatively first.

Second, mortgage companies lowered their standards significantly. This is due in part to aggressive appreciation in home values. The other part of this equation is the competition among banks to put their money to work at higher interest rates. Many smaller mortgage brokers and banks saw the sub-prime lending market as an opportunity to increase margins. These smaller companies lacked the diversification to weather the higher than normal default levels of these loans and were completed unprepared for a negative turn around in the market.

Both of these factors have lead to the current fallout that the sub-prime lending market is experiencing now. The smaller mortgage brokers and banks that were the most aggressive in this market have filed for bankruptcy. The larger banks and brokers are taking huge write-offs and tightening their credit criteria.

How will this affect you?

Sub-prime loans only make up about 8% of the total home loan pool. Additionally, the national default level on these loans is in the high teens. This means that a little over 1% of all US loans are experiencing default due to the sub-prime fall out. This is a very small number.

This fall out will only affect you if you work for a sub-prime lender or if you are applying for a sub-prime loan. With many smaller sub-prime lenders going bankrupt, all banks have tightened their lending criteria for these loans. Some firms have simply stopped making these loans all together. Unfortunately many people who relied on these loans to become homeowners will now be locked out of this market until the dust settles, which could be at least a few years off.