Realty Insider Blog

The media is having a heyday these days with the supposed sub prime meltdown. Apparently the avalanche we will see will cause the US economy to enter into a recession, the stock market to crash and the real estate market to, well, crash. Oh, and Fannie Mae will default and require a massive government intervention to save the stability of the financial markets and retirement funds for all of us... The world is about to come to an end!

Yawn!!! It baffles me why people act surprised - I mean, the name has "sub" before the "prime", indicating that these were less than ideal candidates for a loan. Hence, a slowdown in the housing market would likely lead to an increase in defaults (see below for explanation.)

For those not familiar with the different types of loans: a sub prime loan is generally for borrowers with bad credit, limited income and savings, high debt or a combination of those. Other factors play in as well, all making it harder for someone to qualify for a "regular" loan. 

With the market slowdown, the ability to refinance out of a costly loan diminishes.  Also, the backup plan many relied on over the last few years ("if I cannot pay the mortgage, I will just sell it") is not available as transaction cost and prepayment penalties will require almost anyone that purchased over the last 3 years to bring money to closing (most sub prime borrowers finance 100% of their purchase.)

Ten years ago housing advocates screamed about only the wealthy and privileged being able to participate and benefit from the housing boom. As a result, an unlimited number of loan programs became available to allow people with low income, low credit and no savings. These days, these very same people scream about predatory lending and are asking the government to help the people trapped by these horrible loans.

This is America - you have the right to get yourself in trouble. If that is by maxing out all the credit cards you have or by buying a home you cannot afford the payments on, that is mostly your bad. With great freedom comes great responsibility.  Just because you can buy a double cheeseburger for $1 and eat them all day long won't make McDonalds responsible for you eating yourself to death! (hmm, I believe someone tried to claim that...)

It is tough to draw a line between extending credit to less than ideal credit candidates and denying those same people the chance of homeownership and building wealth. Extending credit (albeit costly to the borrower) to people willing to take the chance is, after allis said and done, one way to make sure that not only the rich and "established" get richer.

A sub prime loan may be more susceptible to predatory lending though and some oversight is necessary. A typical sub prime borrower is a first time homebuyer often with less education or knowledge about finance. That, coupled with many loan officers not really knowing what they are offering, results in borrowers getting stuck with loans they really don't understand or can afford.

With the number of sub prime defaults on the rise, lenders have been tightening up on the requirements for sub prime loans. However, banks have also gotten a lot smarter about how they get rid of properties in default. Instead of auctioning them off at a discount, a foreclosed home now often is sold through real estate agents like any other resale and mostly fetch close to the market price. Also, the number of sub prime loans in relation to the total number of mortgages in the country is very small.

With that in mind, I don't believe the current level of defaults will have any significant influence on housing prices. I believe prices will remain flat this year and possibly next. After that we should see a return to a 3-5% yearly appreciation.