In recent years, many homeowners have taken advantage of non-traditional adjustable rate mortgages (ARMs) that provide low introductory interest rates. However, the “teaser” rates on these mortgages rise sharply after the initial period. Buyers not prepared for this increase may find themselves in the position of having taken on a loan with larger monthly payments than they could handle.
But there’s good news ahead. In April, Freddie Mac -- the company mandated by the federal government to encourage a healthy mortgage market -- announced that it would stop buying subprime home loans that carry a high risk of payment shock. Responsible lenders have adopted the new standards, since they should lead to fewer homeowners defaulting on their loans.
The situation in today’s mortgage market is partly due to the recent housing boom. While many homeowners benefited from skyrocketing house prices, the boom also led to a huge increase in the number of mortgages granted to people with poor credit. In 2006, these so-called subprime mortgages accounted for one in five home loans, compared with just one in 20 five years before.
Many home buyers with shaky credit signed on for mortgages such as 2/28 hybrid ARMs, which provide a low introductory rate for two years before switching to a higher, fully indexed rate for the remaining 28 years. The problem was that when this sudden jump in the size of their monthly payments occurred, many borrowers were overwhelmed by their new obligation. As a result, in recent years, the number of foreclosures has been on the rise.
Fortunately, the climate is changing, and mortgage lenders across the country are tightening their standards to protect borrowers from default. By the fall of 2007:
• Responsible lenders will ensure that their customers qualify for loans at the fully amortized, fully indexed rate (the higher, final rate the loan could jump to and the resulting higher monthly blended principal and interest payment required to pay it off at maturity) rather than just at a low introductory teaser rate.
• There will be more restrictions on low-documentation loans (loans that allow you to pay a higher interest rate in exchange for providing less personal financial information), to ensure that borrowers have the income and assets they need to comfortably carry their loans.
• In order to provide borrowers with safer mortgage options, Freddie Mac is developing new hybrid ARMs with smaller margins and less volatility.
• The new lending standards will make it more important than ever for prospective home buyers with poor credit to work hard at raising their credit scores and saving for a down payment.
If you currently have a subprime mortgage and worry you may not qualify under the revised guidelines, you may want to consider refinancing before September 1, 2007, when Freddie Mac’s new standards go into effect.