On Tuesday the Fed moved one step in the right direction towards reducing the shady lending practices that have put this country in a difficult situation. If you haven’t heard, the real estate market and financial sector has been in a lot of trouble recently due to some questionable lending practices combined with consumer greed. So, the Fed has decided it is time to regulate what should have been common sense.
Highlights of the Plan
This new plan addresses a few key issues, many of which would seem like common sense to any prudent person, but apparently these are some of the primary reasons we find ourselves in this debacle.
- Restrict lenders from penalizing risky borrowers who pay loans off early.
- Require lenders to make sure these borrowers set aside money to pay for taxes and insurance.
- Bar lenders from making loans without proof of a borrower’s income.
- Prohibit lenders from engaging in a pattern or practice of lending without considering a borrower’s ability to repay a home loan from sources other than the home’s value.
Call me crazy, but don’t these issues seem like something a lender should be taking into account before lending someone hundreds of thousands of dollars? Oh that’s right, these loans are offered by salespeople who are paid on commission, so they couldn’t care less about the above issues. But I digress, greedy consumers who got in over their head are as much at fault as those who let those people borrow more money than they should have. So, let’s take a look at each of the issues by itself.
Restrict Lenders From Penalizing Risky Borrowers Who Pay Off Loans Early
I wasn’t aware of this practice until I read this article and did a little bit of research, but I was blown away to see some of the penalties that lenders put in place for subprime borrowers who wanted to refinance or otherwise pay off their adjustable mortgage early. According to the Center for Responsible Lending, these exit fees, called prepayment penalties, were added to more than two-thirds of adjustable-rate loans.
What a kick in the pants this is for the borrower–first you get talked into an ARM with a teaser rate, and when you spend a few years possibly building up your credit and find yourself ready to refinance into a fixed rate mortgage, you’re slapped with a stiff prepayment penalty of sometimes upwards of $9,000 on an average mortgage. Sure, this is great for the lender because they make the penalty stiff enough that you are probably likely to stick with the rate adjustment upwards instead of forking over that cash or refinancing that additional amount into your new loan. It is a win-win for the lender, and it is good that the Fed is addressing this practice.
Require Borrowers to Set Aside money to Pay for Taxes and Insurance
For most people, an escrow account is just a fact of life when it comes to owning a home. Part of your monthly mortgage payment goes into the escrow account so that you have enough money set aside to cover things like property taxes and homeowners insurance. The fact that lenders were structuring loans, especially to subprime borrowers without this is sickening.
Think about it–even a relatively modest mortgage of around $200,000 is going to carry significant property tax and insurance costs. A home of this value in a relatively modest area will probably run around $1,000 per year for homeowners insurance, and most likely, between $2,500-$4,000 per year in property taxes. Sure, $4,000 might not sound like a lot of money, but when a family isn’t setting aside a little bit each month to cover this cost, when that property tax and insurance bill comes due, what happens? If they haven’t saved up enough money, they will have to skip something–a car payment, the taxes, the next month’s mortgage, etc. Whatever the case is, this is a horrible practice that will hopefully be addressed in the new plan.
Bar Lenders From Making Loans Without Proof of a Borrower’s Income
Do I really need to bring up common sense again? Let’s look at this situation in reverse. Say you have $100,000 to invest in just one stock in the entire stock market. Would you invest your money in a company that has proof of earnings and profit, or would you invest in some unlisted company that has no annual reports but claim they have some fantastic new idea that will be the next Google? Of course, you want to invest in a company that has a track record.
Unfortunately, many lenders abandoned this practice to give loans without documentation. Don’t have a tax return or a steady job? No problem, we’ll give you a loan based on whatever you tell us you can pay. Is that a good business decision? Of course not, but the banks were banking on the fact that the real estate market would drive the price of the home up enough that even if something were to happen and you couldn’t keep up with payment that they would still come out ahead.
I can somewhat empathize with self-employed individuals though, because when we were shopping for a mortgage a few years ago, I was self-employed and only my wife had a steady job. So it was difficult to find an attractive mortgage that included both of our incomes. So, for someone or a family that relies entirely on self-employment income that can fluctuate drastically, this is an issue. But again, home ownership is a privilege, not a right. If you just started a business a year ago and haven’t turned a profit yet, there is no reason to feel entitled to owning a home, and you should have to provide at least a small track record before a bank agrees to lend you a substantial amount of money.
Prohibit Lenders from Lending Without Considering a Borrower’s Ability to Repay a Home Loan From Sources Other Than the Home’s Value
This is another great issue that should be addressed, and I’m glad it is a part of the new plan. The banks were speculating, plain and simple. They knew that in the past, real estate values were going up by leaps and bounds over the past few decades, so they weren’t concerned with how a borrower could repay the loan. They knew that the property itself was increasing in value so rapidly that if the borrower came into hard times, they could just refinance or tap into the equity to make things better.
Well, that sure backfired when home prices stopped increasing by 10% a year and became stagnant and even declined, didn’t it? This is no different than if your financial advisor advised that you put your entire retirement savings into technology stocks in 1999. It is simply speculation, and in this case, both the lenders and the borrowers got burned by thinking that past performance was an indication of future returns.
Too Little Too Late?
Some think so, and it may be true that it is too late to help those who are already in trouble. Even so, is any of this rocket science? From a pure business standpoint, these basic issues should be considered before lending anyone money. It all came down to greed. The lenders saw low interest rates and the booming real estate market as an opportunity to make more money by lending to people who otherwise wouldn’t qualify. On top of that, people who had no business buying a $500,000 house got sucked into one because it seemed like they could afford it, or they expected to double their money in 5 years with the way the market was going.
So instead, we all lose. I’m against further government regulation in almost every capacity, but if this is what it takes to get people to get a grip on reality, then so be it. You can blame the lenders and you can blame the borrowers, but in the end, we all pay for everyone’s stupidity.
Author: Jeremy Vohwinkle
My name is Jeremy Vohwinkle, and I’ve spent a number of years working in the finance industry providing financial advice to regular investors and those participating in employer-sponsored retirement plans.
I am in a upside mortgage situation, by about $75,000. My rate is going to go up from 7% to 10.7 in 2 months. I was told my rate was not adjustable, but it is. I have owned my home for 2 years. Is there any programs out there that might benefit me. I have put so much work into my home I really want to keep it.
Thanks for any help you can give me.
These new measures are good and is a step in the right direction. What should be curbed is the over aggressive marketing on mortgages.
"Bar lenders from making loans without proof of a borrower’s income." As someone who was strictly self-employed for several years (and who got two no-doc loans) I'd say this one makes sense IF "proof of a borrower's income" includes things like your previous year's tax return and bank statements from the current year. Those weren't considered enough "proof" of income according to the people I talked to when I tried to get a documented loan instead. (Because who wants to pay no-doc interest rates if you don't have to?)
I know, for a mortgage the prepayment penalty doesn't make much sense. From a business standpoint, yes, the bank needs to make money, but since mortgages are front-loaded with the bulk of interest payments in the early years of the loan, they are still making some money. Maybe not as much compared to if someone kept the loan in its entirety, but it still isn't a very consumer-friendly practice.
I hadn't heard of the prepayment penalty either. Penalizing people for being responsible...that's a recipe for disaster. The other ones are dumb, too, but someone the penalty seems even worse.