California and Subprime Loans

If the only thing you've done is turn on the television, you've heard over and over about "subprime" loans. Many people are unfamiliar with a lot of loan terms, and that includes those working in the real estate industry, but just know that because you're shopping for a loan now doesn't mean you're automatically going to get a "subprime" loan, because there are many loan choices. The individuals who've experienced trouble, so often the subject of the news media, are those whose credit scores were lower, so they were offered loans not at the prime market interest rates, but at higher rates with other conditions which led to them not being able to afford their payment when it reached the "fully indexed" level, meaning loan plus margin (the lender's set profit zone). These loans contained terms and condition not understood by the buyers, who for instance thought a 2-month or a 12-month 1% start rate was the actual interest rate, and did not understand what the annual increases would be on their loan, or what that would mean to their payment.

Before you read further, if you're a buyer currently searching for a loan and you have good credit with a strong mid-score over 680 (you knew there are 3 FICO scores, right?), you are not this kind of borrower.

Thus, the following excerpt from California's Department of Real Estate Bulletin, Spring 2007 where a borrower has a 1% start rate, payments increase annually while the deferred interest is added to the loan principal, and after 5 years go to the full payment level, while the loan principal has increased:

We have analyzed the impact on a buyer who takes a $300,000 payment option ARM and makes the minimum payments of $965.00 per month. The analysis is based on an actual adjustable rate note from a national lender. The note provides for first year payments based on a 1% interest rate, annual payment increases of no more than 7 ½% of the previous payment for 5 years after which full payments must be made to amortize the loan over the remaining term. Interest is adjustable monthly beginning after the first month based on the Twelve-Month Average of monthly yields on actively traded United States Treasury Securities adjusted to a constant maturity of one year as published by the Federal Reserve Statistical Release entitled “Selected Interest Rates (h-15)," otherwise known as the MTA. The margin is 3.10. Maximum deferred interest (negative amortization) is 115% of the original principal balance. There is no cap on the monthly rate increases and the life cap is 9.95%. As of the date this article was written, the index value for the Monthly Treasury Average was 4.88 making the fully indexed interest rate 8.0% after rounding. Let’s assume that there are no increases in the index for the first 5 years (a very conservative and unrealistic assumption). The loan term is 360 months.

After year one the balance has increased, because of negative amortization, from the original $300,000 to $312,814; after year 2, $325,787; and after year 3, $338,861. After the 43rd month, the deferred interest maximum is met ($345,328). Since there have been payment increases of 7 ½% each year, the monthly payment of $1,199.00 after year 3, would increase to $2,604.00 per month (the fully amortizing payment over the remaining 317 months) – an increase of $1,405.00 monthly barring any interest rate increases for the life of the loan. Considering that the one-year Treasury Security index value has increased almost 400% since January 2004, even though interest rate increases have slowed recently, the likelihood that this loan would achieve its maximum interest rate of 9.95% is very good. If that were the case after 43 months, the monthly payments would have ballooned to $3,063, a 317% increase from the original payment of $965.00.00 per month. Unless the buyers have planned for the payment increases by either expected increases in income, setting aside all or part of the monthly payment differentials, or some other financial plan to meet the increased debt service, the financial impact could be severe.

Some lenders are now doing the logical thing by making the buyer qualify not just at the initial rate, but the full payment level to avoid this situation, and the Department of Real Estate in the same article now states the real estate agent is to review loan document terms and conditions with the buyer.
NOTE: In a revised statement released on April 12, 2007, the DRE clarified that it "is the fiduciary duty of each licensee who represents the borrower in obtaining a loan to completely explain the terms and discuss the relative merits and risks of these loan products well before the point of signing loan documents." Buyers really must understand the basic terms they are agreeing to.

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