Editor’s note: Steven Krystofiak offers an insider’s take on what’s been unfolding in the subprime mortgage industry. But he is no industry apologist. Stay tuned for a series of articles from Krystofiak on Inman News in coming weeks. (Read the first article, “What is a subprime loan? It depends on whom you ask.”)
Since the turn of the century we have seen a dramatic rise in use of neo-affordability products. Do these products really make homes more affordable? They without a doubt make the monthly payments temporarily lower, but affordable? Let’s take a closer look.
I want to take a step back and explain the products that I am talking about. They are the often-used interest-only, negatively amortized, no-money-down and extremely short-termed fixed loans, i.e., the 2/28s and 3/27s. The last products on the previous list are usually associated with equally long stiff prepayment penalties. The close cousin of the 2/28s is the 5-year fixed mortgage that I choose not to include on this list in the interest of narrowing today’s article.
If people want to buy a home or condo with the intent of living in it and then sell it just two or three years later then maybe a 3-year fixed mortgage is right for them. Before making that purchase, the potential home buyer should be guided to plug in the numbers for their situation with the hardly used and dusty old “rent vs. buy calculator.” With the large gap between current rents and PITI payments coupled with expected appreciation rates for the upcoming years, buying does not make sense in most markets if the holding period is less than five years. Blasphemy, I know, but it is what the calculator says.
It is easy to throw out rent vs. buy calculators when home prices are appreciating 10-20 percent a year. With normal market conditions appearing throughout the U.S., and possible depreciation around the corner, a crash course for this old hardware should be a must for anyone in the industry specifically for any potential home buyer.
Interest-only loans have become the new standard in many real estate markets. If you want to compete in the home-buying process with equally qualified peers then you must use an interest-only loan. This mentality creates more debt and is bad for local markets. It has both caused and allowed people to purchase higher priced homes.
At first, this sounds great but you must realize that a home buyer’s main focus is the monthly payment. This equates to people buying the home down the street for a monthly price tag, not a $400,000 lump sum. If interest-only loans never reared their dirty heads into the market, the same home down the street would still be a $2,200-a-month home, but what would be nice is that the balance of the loan would be going down and Americans would be much less in debt.
The above example’s principles can be brought over to the newer and, in some markets, more popular negatively amortized loans. Hopefully in the future, negatively amortized loans do not become the standard as their counterpart, the interest-only loan, did. Otherwise American debt levels will never stop growing.
The expression, “Don’t hate the player, hate the game,” can be used to describe interest-only loans and negatively amortized loans. You might not like that you are using it, but to compete with others playing the game of real estate you must take on the risk. This practice will keep your mortgage balance unchanged, or in some cases cause it to grow higher, month after month, leaving the answer to “How long can we keep this up?” very uncertain.
One-hundred-percent financing puts the financial risk of the unknown future of home-price appreciation on the shoulders of the bank. Not the consumer. This is a trait I look for when trying to label something as an “affordability” and “consumer-friendly” product.
If home prices decline, we can see a newly informed consumer simply give up his home to foreclosure — this option is great for the individual consumer. This would put less of a financial risk on a home buyer who would otherwise have needed to come up with $100,000 of his own money to purchase a $500,000 home. For many consumers, simply damaging their credit scores instead of losing years of savings could be an easier weight to bear. But if everyone’s neighbor begins to do the same thing, it could take down the local economy. This causes me to think that 100 percent financing as a whole for the economy is a very dangerous thing.
Answering the original question: Are these affordability products? I don’t think so. A proper name for these products is obtain-ability products. That is what the loan is allowing the borrower to do — obtain a home. These products depend on and almost require large increases in household income along with home-price appreciation. These obscure guesses and assumptions should not be given so much weight when contemplating such important life-altering purchases.
Homes should stay homes. If they go up in value or down in value they remain a place to rest your head and raise a family. With a proper loan for a home the average household should be able to weather any downturn in the market. As recent history is showing us these proper loans were not adopted by many home buyers. This leaves future predictions for the real estate market dependant upon the success of the guesses and assumptions that recent home buyers blindly believed when obtaining loans.
Steven Krystofiak is a mortgage broker based in California. He is president of the Mortgage Broker Association for Responsible Lending, an advocacy group.