Foreclosure Epidemic-Bad As It Seems?

Is The "Foreclosure Epidemic" as Bad as It Seems?

I'm sure that you have heard that foreclosures have increased.
The national and local media publicize the statistics that defaults
are up from last year on a month-to-month comparison.

The primary segment of the mortgage business that has exper-
ienced the biggest problem is the "sub-prime" loans.

When you consider the spectrum of lending, the most qualified
borrowers who seek mainstream lending products are classified
in the "A" category.

Qualified borrowers who seek less mainstream products, or who
need to obtain loans that allow them to borrow as much as 95%
to 100% of the purchase price are commonly classified in the"A-"
category.

When you categorize borrowers who have diminished credit
scores, who need loans approaching 100% of the purchase
price, and who may have difficulty documenting their income
and assets, they fall into the "B" and "C" classifications.
This is the category that is commonly called "sub-prime".

Over the past few years, the lenders and investors who purchase
loans have been much more liberal in their willingness to approve
loans in the "sub-prime" group. They were willing to accept
lower credit scores than normal; they were willing to accept
borrowers who merely stated their income without asking the
borrowers to prove it; they were willing to accept borrowers who
did not have much in the way of provable assets for downpayment,
closing costs, and cash reserves.

The media and legislators are making headlines out of the fact
that foreclosures have increased. There are some calls for more
legislation to protect borrowers from potentially losing their homes.
They suggest that all the defaults may be a result of
predatory mortgage practices and bad faith on the part of the
lenders to put people in this position.

The fact that lenders have been more permissive in the approval
process in the recent past has been a very good thing for many
people.

The appreciation of home values can be directly tied to the fact
that more borrowers had been able to qualify and that increased
demand kept prices high. The slowdown in property appreciation
and lenders tightening their underwriting practices have been
occurring at the same time.

The bigger point that I want to make is that there are many
people who want the American Dream of home ownership. If
we adhered to the old paradigm of loan approvals, we would
expect every loan to be fully documented, for borrowers to
have 20% cash down payment, and to have strong credit
histories with only the occasional blemish on their credit reports.

This old underwriting standard would eliminate many borrowers
from ever having a chance at home ownership. Because the
lending industry was creative in the development of new mort-
gage products and felt comfortable to be more liberal in their
qualifying (especially when they thought that property values
were increasing), many people were able to move from being
renters to homeowners.

Once they became homeowners, they have an opportunity for
any appreciation in property values to start adding to their
equity and to their net worth. They are no longer on the outside
looking in.

One statistic I heard recently was that about 13% of the sub-
prime borrowers were facing default and foreclosure. As bad
as that is for those borrowers, it still means that 87% of these
"lesser" qualified borrowers were still maintaining their payments
and still having the opportunity to build equity over time.

Now, please don't misunderstand me. I do not want to see
anyone lose their home to foreclosure. I especially feel bad for
borrowers who were not well-advised by their loan originator as
to potential risks for certain loan products that may not have
been a suitable fit for them. (You know that I have railed against
those less-than-scrupulous lenders who see borrowers
as dollar signs, and not as real people that deserve respect and
suitable advice.)

I don't think, however, that the system is broken when a certain
percentage of homeowners don't succeed in keeping their homes.
I don't think there is any benefit for legislators to create more laws
to protect against this spike in the number of foreclosures. Market
forces will be able to adapt to this much more efficiently and effectively.

Lenders will cut back on their approval process (like they are
now doing). They will insist on higher credit scores. They
will insist on the borrowers proving their income and their
assets to show that they providing accurate information for the
lender to make their decision. There will be fewer "unqualified"
borrowers obtaining home loans and once these new standards
are in place, there will be fewer foreclosures going forward.

I think it is important for us to realize that more people have
benefited from the opportunity to buy homes, to provide a more
stable home environment for their families, to realize the benefits
of the tax law for interest and property tax payments
(instead of paying rent and buying the landlord's property for
the landlord's benefit) and to have the pride of ownership that
comes with all of that.

The pendulum swung too far to the side of laxity in under-
writing and is now correcting itself by adhering to stricter
standards. The system works, despite some rough patches
at times.

PMI Making A Comeback

PMI-Private Mortgage Insurance-is making
a comeback

In the mortgage lending business, a loan that is 80% of the value
of the home is considered to be a normal risk for the lender and
is considered to be the industry standard.

If a borrower needs financing that is more than 80% of the value
of the home (loan-to-value, LTV), that would represent a higher
risk to the lender and would be considered if the borrower has
better qualifications and if the lender were to receive higher than
normal rates and fees to compensate themselves for the higher
risk, or if that higher risk could be passed along to another party.

Private Mortgage Insurance (PMI) was developed in an effort to
give the lenders a feeling of comfort that they were not taking an
undue risk, and still provide a means for borrowers to obtain
home financing without needing 20% down payment.

PMI provides insurance to the lender in the case of a default in
payments by the borrower which would result in a monetary
loss to the lender. The borrower will be the one who pays the
cost of the policy and the premiums are usually collected with
each monthly payment from the borrower.

Let's take a look at an example. Let's say that the borrower is
buying a home valued at $500,000. They are able to provide a
down payment of $50,000 and they have additional funds for their
closing costs and cash reserves after closing. They need to
finance $450,000 which is a 90% LTV.

In the past few years the most popular way to put his
transaction together was to create a first loan of $400,000
(80% LTV) and couple it with a second loan of $50,000 for a
combined LTV of 90%. This was preferred because the first
loan was at the industry standard of 80%, so it was acceptable
risk to the lender and did not require PMI and was offered at
competitive interest rates and fees. The second loan of the
additional 10% was where the lender was experiencing the
additional risk. Rates and fees were higher only on this portion
of the financing to reflect that higher risk to the lender. Also,
the mortgage market was eager to create these second loans
because investors could receive higher rates, property values
were increasing and mortgage defaults were not common.

I'm sure that you have been hearing and reading that more
recently property values have leveled off and diminished in some
areas, and that mortgage defaults have increased. This has led
to less willingness of the lenders to create these second loans,
especially where the combined LTV was at 100%. As the
availability of these second loans is diminishing, we are seeing
that lenders are more willing to create one loan and to reduce
their risk by using PMI again.

The way the transaction would be put together using PMI is by
the lender creating a loan of $450,000 (90% LTV). The interest
rate on the loan itself would be at competitive rates and fees,
but the borrower would be required to qualify for and provide a
PMI policy to the lender. The PMI company would charge a
premium based on the LTV, whether the loan is fixed-rate or
adjustable-rate, whether the borrower qualified by providing
full documentation or was using stated income. The cost of
this policy could be in the range of $200-$300 per month.

But, it is a lot less expensive than trying to save another
$50,000 and missing out on home ownership in the meantime.

PMI is currently tax-deductible for borrowers whose adjusted
gross income (AGI) is $100,000 or less, is partially deductible
for AGI between $100,000-$109,000, and loses its deductibility
for AGI above $109,000.

Some lenders may offer to charge a higher rate on the loan, and
to have the mortgage insurance paid by them. This will then
show as interest being paid by the borrower, not insurance
premium, and will increase the chances of tax deductibility
without concern over the AGI limitations.

As always, there are many nuances to be explored to make sure
that you are being well-served by the mortgage recommendation.
Be sure that you are getting complete information to make an
informed decision.