Page 24 - Impact: Collected Essays on the Threat of Economic Inequality

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The Variety of Subprime Loan Approaches to Bridging the Affordability Gap16
Adjustable rate mortgages were one of the artifices used to qualify borrowers with high debt- to-income ratios . Adjustable rate mortgages arrived on the scene in the late 1970s and early 1980s, when double-digit prime lending rates imperiled the affordability of consumer credit . By offering a rate floating by reference to a market index, lenders could reduce the cost of the initial interest rate, as the rate no longer needed to account for the risk of inflation throughout the life of the loan .17 Thus, adjustable rate loans were invented with the aim of lowering the cost of mortgage financing, at least initially . Of course, from the borrower’s perspective, if inflation and other factors such as reduced investor demand drove up rates during the life of the loan, the adjustable loan could end up more expensive than a fixed rate loan . Also, because there is not necessarily a correlation between upward adjustments in the market interest rate over time and the borrower’s wages, it is dangerous to approve the borrower for a loan using the initial interest rate to calculate affordability, as later rate increases might outpace any wage increases . Adopting this model of qualifying borrowers for financing based on the initial adjustable interest rate, subprime lenders upped the dangerous ante by offering teaser/special introductory interest rates . Teaser rates (which might be in the low single digits) were effective at the outset of the loan for a defined period, often from one to three years, after which the loan would reset to a specified adjustable rate formula producing a rate considerably in excess of the teaser percentage, without regard to actual fluctuations of interest rates in the marketplace, in order to compensate the lender for the below-market introductory rate . By qualifying the borrower at an introductory interest rate of (say) 3 percent instead of a prevailing market fixed rate of interest of 6 percent, the mortgage lender could approve an adjustable rate applicant with considerably less income than a fixed market-rate loan applicant . But beware the date of the reset, as no doubt the borrower cannot expect a salary bonanza at her work coinciding with the reset that might more than double the previous monthly loan payment .
Other innovations stemmed from the desire to artificially lower the monthly loan payments . Rather than lowering the interest portion of the payment, monthly payments could be reduced by stretching out the loan amortization period or eliminating amortization of principal entirely by means of interest-only payments for the life of the loan . Traditionally, home mortgage loans (at least in the modern era after the creation of the Federal Home Administration) offered the borrower thirty years to pay off the loan, with each monthly payment including the accrued interest and a portion of the loan principal amount calculated so that after the same monthly payment amount over 360 months the loan balance would be fully repaid . Reducing the loan period to fifteen years for a fully amortized loan would significantly boost the monthly payment amount, yet lessen the lender’s risks of default collectability and inflation, resulting in a lower interest rate . But instead of encouraging such a reduction of the loan repayment period, some subprime lenders stretched the loan term in the opposite direction beyond thirty years, offering forty-, forty-five-, and fifty-year repayment periods, with the goal of reducing the monthly payments despite the potential for a slightly higher interest rate to cover the additional risk of
16 For further discussion of subprime mortgages, see generally Bender, Tierra y liBerTad: land, liBerTy, and laTino housing, supra note 3, at 45-56.
17 Still, the rate needed to account for the risk of default and the prospect of the lender failing to realize the full balance of the loan through its enforcement remedies (in theory this risk can be spread across a variety of loans to compensate the creditor for just those loans that fail, which traditionally has been a small percentage for residential lending outside of the subprime mortgage crisis and the Great Depression), as well as the lender’s cost of borrowing the funds it in turn lent to the borrower, and a reasonable rate of return on the lender’s investment in lending the funds.
Impact: Collected Essays on the Threat of Economic Inequality