"ONE IN EIGHT SUBPRIME LOAN ENDS IN FORECLOSURE WITHIN 5 YEARS..."

Trouble Ahead for Subprime Borrowers
Expect to see foreclosures on subprime or nontraditional loans - mortgages made to consumers with impaired credit - to accelerate, according to the Center for Responsible Lending, a nonprofit research organization.

A recent CDL report, which analyzed more than six million subprime mortgages made from 1998 through the third quarter of 2006, estimates that 2.2 million households in the subprime market have either lost their homes to foreclosure or hold mortgages that will fail this year. The cost to home owners could be as high as $164 billion, primarily from lost home equity.

Even during years of strong appreciation, as many as one in eight subprime loans ended in foreclosure within five years of origination, according to CDL.

In the last couple of years, there has been a large increase in nontraditional mortgage products, including interest-only loans and payment-option adjustable-rate mortgages (option ARMs), in which the borrower has flexible payment options, says Federal Reserve Gov. Susan Schmidt Bies. In fact, recent estimates show these types of mortgages accounted for about one-third of all U.S. mortgage originations in 2006, compared with less than one-tenth just a few years earlier. Bies spoke Jan. 11 at a Risk Mitigation Summit sponsored by the National Credit Union Administration.

Catch 22 of Subprime Loans

The CDL maintains that "borrowers who are already financially vulnerable are receiving loans that are known to pose a higher risk." Balloon payments, prepayment penalties, and limited documentation make subprime mortgages particularly vulnerable to foreclosure. A good example, according to CDL, is the "exploding ARM." It features semi-annual rate adjustments following an artificially low introductory rate.

"It isn't surprising that some borrowers can't keep up with their payments once their loans fully adjust," said Bies, noting that it's not unusual to find margins of 6 percent or higher.

Two other factors adding higher risk for subprime borrowers are loose underwriting practices and lack of accountability, analysts say. "Mortgage lenders have relaxed credit standards and issued loans with a much higher risk of foreclosure," says Mark Dotzour, chief economist for the Real Estate Center at Texas A&M University.

Additionally, according to CDL, many subprime lenders don't take into account whether the home owner will be able to pay the interest rate when the loan resets nor do they take into account insurance premiums and real estate taxes.

Subprime borrows also struggle to accumulate equity since some loans limit the amount of equity a borrower builds. Plus, some borrowers are having difficulty refinancing to avoid foreclosure, particularly due to prepayment penalties and slowing home price appreciation.

- By Camilla McLaughlin for REALTOR® Magazine Online