Risky Home Lending Worries Mortgage Backers

Low interest and interest only loans increase risks of foreclosure

In years past, the lending industry was a safe one for investors. Along with utilities, such as power and phone companies, mortgage lending was regarded as a safe, if unexciting, place to invest money. The yields were small but steady, and foreclosure rates were fairly low. Americans sometimes default on their loans and encounter problem debt, but they usually make their house payments. After all, everyone needs a place to live.

In recent years, that has changed. The collapse of the stock market in the late 1990’s has prompted an unprecedented spurt in the growth of the real estate market. Investors, shying away from stocks, have begun buying homes for speculation. Average Americans have decided to sink their money into real estate, too, buying ever-larger houses. This has caused an incredible rise in the prices of houses nationwide, and it has completely changed the face of the mortgage industry.

With salaries stable and prices rising, the traditional 30-year fixed-rate mortgage no longer works for most borrowers. They simply cannot afford to purchase homes using those terms. As the lending industry makes money only when they actually lend, they have responded with a bewildering array of loans, including more than a few that come with increased risks. Nearly one-third of all new mortgages issued are interest-only loans, where the borrower pays back on the the interest on the loan for the first five years of so of the repayment schedule. Another popular choice is the incredibly dangerous Option ARM mortgage, which comes with “teaser” interest rates of as low as 1%, but can bite the borrower in a big way by actually causing the loan amount to increase even as payments are made!

The proliferation of these high-risk loans and the increasing reliance upon them has mortgage company stockholders concerned, and justifiably so. Foreclosure rates throughout the United States are increasing rapidly, as more and more borrowers with high-risk mortgages realize that they have purchased homes that they cannot afford. As foreclosures increase, so do sales of mortgage company stocks as investors have started to panic.

Financial services stocks make up more than one fifth of the Standard & Poor’s 500 index in terms of value, and studies show that in the last month or so, prices of financial services stocks have declined dramatically. This will likely lead to a tightening of lending practices, as lenders cannot offer loans if they have no money to lend. More and more would-be borrowers will find their applications for home loans denied. As lenders become more cautious about offering loans, fewer homes will be sold, which may bring about a substantial reduction in house prices nationwide. Worse, more borrowers will be forced to obtain higher interest loans, known as subprime loans, that come with high closing costs and interest rates. A collapse of housing prices could be serious, as it could leave millions of homeowners with properties that are worth less than the loans issued for them, and that, ultimately, could lead to a crash of the real estate market.

At the moment, this is all speculation, as it’s too early to see exactly where the market is headed. Borrowers should be cautious, as always, about borrowing money with risky terms. Don’t buy more house than you can afford to pay for, and you will come out OK.