Subprime Mortgage Blues

In March 31, 2007
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So far for 2007, it’s been very busy here at ZipDebt – hence the infrequent blog posts over the past few months. One of the reasons for the increasing number of people seeking help with credit card debt is the subprime mortgage problem that’s recently been in the news.

After seeing countless people buy $700,000-$800,000 homes here in the San Diego area, and scratching my head as to how average people could possibly afford such huge mortgages, it’s now becoming quite clear that many of these folks never really could afford those expensive homes in the first place.

There’s a reason why conservative lenders still use the old 28/36 rule for debt-to-income ratio analysis. Your housing expenses (mortgage principal + interest + property taxes) should not exceed 28% of your gross income, and your total debt payments (housing + auto loans + unsecured obligations) should not exceed 36% of your gross income. When the ratios climb much higher than that, people have to start borrowing more just to stay afloat, and the household budget becomes very unstable.

So I’ve been hearing from quite a few people lately who are trying to get out from under properties that are at risk of foreclosure, after the payment on their adjustable-rate mortgage (ARM) increased to the point where they can no longer handle the higher payment on top of their existing credit card bills.

Adjustable mortgages are potentially risky enough. But I can’t how imagine anyone in their right mind would take on a “creative” mortgage, like the 1% loans that were a staple of the subprime market last year. With real mortgage interest rates at 5%, how could a 1% loan even exist? Well, it’s called negative amortization, where you make your payment but you end up owing more at the end of the month that you owed at the start of the month. That’s because the payment does not even cover the full amount of interest on the note, so the amount you owe climbs with every payment. It would only make sense to consider such a loan if you were 100% certain that the value of your property were going to appreciate much faster than the increasing debt associated with the negative amortization. And plenty of people who got into such loans assumed just that — they expected the steep rise in home prices to continue. “Hey, no problem. Our equity will be up $100,000 in a year or two, and we’ll just refinance and get a regular mortgage.”

In investing, this is called “the greater fool theory,” where a person pays sky-high prices for an investment because they are convinced a bigger fool will come along and pay an even higher price. But such run-ups never continue indefinitely. Eventually, conditions change and the market flattens out or even crashes. We haven’t seen an actual crash in the real estate market yet, but we’re certainly seeing downward pressure on prices as foreclosures mount across the country.

Add $30,000, $50,000, or $100,000 of credit card debt on top of a ballooning mortgage payment, and you have a fast track to financial disaster. I expect debt companies will have trouble keeping up with the flow of new clients as we roll forward through 2007.


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