Owning your own home has long been the American dream. But for many today that dream is being caught in a squeeze play scenario with a growing number of cash-strapped homeowners on one side and a steady stream of unscrupulous lenders who offer "Cinderella" or exotic mortgages on the other.
Experts say it is this combination that is partly responsible for the alarming rise in mortgage defaults and foreclosures causing nightmares for homeowners in many parts of the country, especially the Midwest, the Southwest and the West Coast.
How does this happen?
It can be traced back to a number of factors from over-extended borrowers to an increase in lax lending practices that lure unsuspecting consumers with low- or no-down-payment, interest-only loans or mortgages with incredibly low initial interest rates that skyrocket once the rate adjusts to its "real" interest rate.
Another factor has been the recent rise in interest rates for adjustable rate mortgages (ARMs), which account for nearly one in every four of all mortgages sold. According to the Mortgage Bankers Association most ARMs are held by people with poor credit.
Adjustable-rate mortgages used to offer interest rates that were substantially lower than 30-year fixed loans.
That's no longer true. For the past two years, the Federal Reserve has been raising short term interest rates so that now the average interest rate on a 30-year fixed loan is about 6.18% while an adjustable rate mortgage is 5.9%, a difference of about one-fourth of one percent.
The Foreclosure Process
If you've never been in a foreclosure situation, count yourself lucky. Here's how the foreclosure process works.
First, if you fall behind on your monthly mortgage payments, the bank or lender sends out a default notice. Most homeowners are able to stop the foreclosure process by bringing their mortgage payments up to date or refinancing the mortgage. Some have to sell their homes to in order to pay off the mortgage.
A growing number, however, are finding they can't do either -- because of job loss, medical expenses and other debts, they can't raise the money to pay off the mortage. And because of the weak real estate market, they're unable to sell their home for what they owe on it.
In those cases, the lender takes their home away from them and, as nightmares go, the idea of being homeless is among the most frightening.
It's estimated that nearly 20% of those homeowners who were in default earlier in the year, lost their homes to foreclosure in the third quarter. That's a more than a three-fold increase over last year, when the default-to-foreclosure rate was only 6%.
First American Loan Performance, a mortgage-data company based in San Francisco, says overall the national foreclosure rate has climbed 27% from a year ago with an estimated $110 billion worth of homes expected to go into foreclosure.
California home-loan defaults rose to their highest level in four and a half years. In Orange County alone, 79,000 loans are at risk and an estimated more than 18,000 of them will default in the next five years. Texas is also running higher than the national average, as well as other areas of the Southwest and Middle America.
Many foreclosure victims are finding themselves caught between the rise in interest rates and falling home prices.
Of these, there are three types of borrowers that get in trouble:
• those with "teaser loans" that have highly discounted initial payments,
• those whose down payment is 15 percent or less of the purchase price, and
• homeowners with more traditional adjustable-rate loans but who put down only 5% or less.
The problem stems from their lack of equity in the homes, especially if they want to refinance adjustable rate loans when those rates go up.
Another type is the so-called "sub-prime" borrower, whose debt to income ratio is out of whack, which means his mortgage payment takes too big a chunk of his income. The maximum percentage for debt which would include a mortgage, credit cards and car payments is supposed to be around 36%.
However, some homeowners find themselves paying most of their income to the mortgage, especially after those monthly payments go up higher than expected.
Experts say foreclosures tend to happen to first-time buyers who don't always realize what they're getting into. They don't read the fine print and only see those low initial interest rates.
Meanwhile, new studies show mortgage lenders are continuing to make it easy to get loans even as the number of foreclosures continue to rise. This hasn't gone unnoticed by the Comptroller of the Currency.
In a speech to the American Bankers Association, Comptroller of the Currency John Dugan expressed concern that lenders were easing their standards so they could process more loans, even though the number of defaults and foreclosures were going up and the housing market had cooled down.
He cited a report that showed more than two thirds of the banks that issue loans had loosened their standards for home equity loans and more than 25% eased their mortgage standards.
This increase prompted him to take action. Starting this month, federally chartered lenders are being discouraged from deeming buyers as qualified borrowers based on the low starter rates, when only the interest or a portion of the interest is due.
Instead, they are being told to evaluate the borrower's ability to pay for the loan at the full rate.
Regulators say they'll monitor the lenders to see if they follow the new rules. Those who don't will be asked to take corrective action. Unfortunately, the rules only apply to federally chartered lenders. State-chartered banks aren't covered and there are a lot more of them than there are federal banks.
Still, it's a start.
What Can You Do?
The common wisdom is that owning a home is nearly always better than renting. In fact, this is true only if you are able to meet the mortgage payments. It's a lot worse to go into a foreclosure than to have to vacate a rental property.
Many, if not most, first-time home buyers are over-extended -- they take out a bigger loan than they can afford, trusting that the property will appreciate steadily and the tax benefits of having a mortgage will make up for the cash drain of a big mortgage payments and home upkeep costs.
This strategy works well when the economy is strong and home values are rising ... and when the home buyer has a fixed-rate mortgage. It doesn't work well at all when home values are squishy, the economy is all over the charts and the home buyer has a variable rate or "creative" mortgage.
Suddenly, instead of becoming an appreciating asset, the home comes to resemble a Ford truck -- a black hole that sucks up money for maintenance, taxes and rising mortgage interest payments while declining in value.
Buyer beware! In today's market, many first-time home buyers would be well advised to hold off on that first purchase.
Here are some strategies you might consider if you are considering going more deeply into debt than you can afford:
• Go "downscale." Instead of buying the best property you can afford in an upscale neighborhood, buy a duplex or other multi-family housing unit in a less desirable neighborhood. There is always a demand for moderately priced housing and having one or more rental units contributing to the monthly mortgage can make a big difference. (There are tax benefits to being a landlord too. Talk to an accountant).
• Become a landlord. Don't want to move to a more modest neighborhood? Fine. Stay in your apartment and buy a piece of income property -- a duplex, four-plex or single-family rental home in a "less desirable" neighborhood. You'll need to invest sweat equity in making repairs, collecting rent, etc., but your tenants will be paying your mortgage and building your equity.
• Think big, spend small. The rich didn't get that way by throwing money around. Cash is always king. Cut back on little luxuries -- Starbucks and that big new SUV for starters. Drink Folgers and get a used Corolla. Stash the cash in a 401(k), CD or reputable mutual fund. In a few years, you'll be in a better position to snap up a nice piece of real estate and get a decent fixed-rate mortgage.
Too many consumers today want to get their "dream home" right away. Big mistake. The way to get rich through real estate is to start small and trade up. Buy within your means and, whenever possible, insist on a traditional fixed-rate mortgage.