|From the writer's mailbox, April 20, 2005: The benefits of activating her "pre-approved" Platinum equity card."|
SALEM, Ore. (CNN/Money) – Economists have all kinds of reasonable explanations for the historic housing boom: Low interest rates, demographic trends and supply constraints are the usual buzzwords.
There's another reason, and it's increasingly cause for concern.
"Pretty much anyone can get a loan within reason," said Robert Moulton, president of mortgage brokerage Americana Mortgage Group in New York.
To be sure, many home buyers would not be trading up, buying a first home or investing in a vacation house if it weren't for lower down payment requirements, loans with ultra-low monthly payments and flexible lending standards.
According to Keith Gumbinger, vice president for HSH Associates, the shift in lending standards started after the dot-com stock bust in 2000. As big investors shifted out of stocks and into bonds – such as mortgage-backed securities – banks had more money to lend out.
By 2003, with the refinancing boom coming to a head, banks quickly set about trying to recruit more first-time home buyers, encourage second-home buying and promote home equity lines of credit as an easy and responsible way to fix up the house or finance a vacation.
Last year, according to the National Association of Realtors, 23 percent of houses bought were second homes. The amount Americans owed on home equity lines of credit, according to the Federal Insurance Deposit Corporation, jumped to about $491 billion at the end of 2004, up 42 percent from a year earlier, and more than triple the amount at the end of 2000.
Not everyone sees these as negative developments. Lenders have become more lenient, said LendingTree president Anthony Hsieh, but not because they are irresponsible or irrational. With the help of credit scoring, lenders have fine-tuned how they measure credit risk, he said.
Few people will argue that consumers haven't benefited from these changes. "Keep in mind that 20 years ago you couldn't buy a house unless you had a 20 percent down payment," said Hsieh. "You had three choices of loans, adjustable, 15-year or 30-year."
But are lenders giving borrowers more credit than they deserve?
"Lenders have less of a vested interest in maintaining higher credit standards because they bundle [the loans] and sell them off," said David Joy, chief strategist for American Express Financial Advisors.
"It's like a game of musical chairs," he added. "It works as long as the music keeps playing, but when the music stops the one with no chair is at risk."
One of the first things lenders did to help bring more buyers to the market was remove what was once the biggest hurdle to buying a home – the downpayment.
Over the past few years, low-money-down mortgages have become the rule rather than the exception. Among first-time home buyers in 2004, according to the NAR, the median down payment was 3 percent – half what it was in 2003.
Lenders also rolled out loans designed to get borrowers the most house for the smallest monthly payment. These loans still represent a small fraction of the mortgage market – the majority of all loans are old fashioned 30-year fixed-rate loans – but appear increasingly popular among buyers who can't afford to pay principal and interest on their mortgage every month.
Interest-only loans, as the name suggests, require that borrowers pay only the interest they owe on their loan for the first 5 to 10 years during which time the balance stays the same. Option ARMS give borrowers several payment options, including a "minimum payment" equal to less than the interest. Pay only the minimum and your balance will increase each month.
"For borrowers who are stretched thin, this leaves little equity cushion if the value of the home declines," said Greg McBride, senior analyst for Bankrate.com, explaining that borrowers who have put their own savings into property are less likely to foreclose when times get tough.
Equity might have been the only thing preventing foreclosure a decade ago, said Hsieh, but these days most borrowers understand the importance of maintaining their credit score. "Studies show that if you're a credit worthy borrower, you will do everything in your power to keep your credit high," said Hsieh. "That in itself is skin in the game."
Whereas lenders used to say that borrowers' annual mortgage payments should be no more than a third of their annual income, they now weigh debt-to-income ratios against the credit score and other factors.
"I have seen debt ratios as high as 70 percent or 80 percent," said Hsieh, adding that lenders approve or reject loans based on underwriting guidelines set by Fannie Mae, Freddie Mac and other institutions that bundle and sell mortgages. "But somehow these people have found a way to pay their housing debt and keep their credit score high."
In fact, the percentage of loans in the foreclosure process was a little over 1 percent in the fourth quarter of 2004, the lowest rate since 2000, according to the Mortgage Bankers Association of America. Also, delinquency rates for all loans decreased last year, with the riskiest loans seeing the greatest decline.
The numbers look good now. "But how the borrower performs after taking out the loan isn't' the best indicator of what's to come," said McBride. "The peak for delinquencies and defaults comes between years three and five."
The credit score, meanwhile, has only been widely adopted in the past few years, when rates were low and home prices were rising. "Credit scores absolutely have helped make mortgages available to more people," said Gumbinger. Still, he said, the fact that trillions of dollars are riding on a single number is disturbing.
"What is new today is that lenders are allowing for the layering of risks on top of one another," Gumbinger added. "What we don't know is what if we put all these risks together and put them in a rising interest rate environment, a declining housing market, or a weakening economy."
If music stops playing who's left standing? Lenders might feel some pain, said McBride, but ultimately it's the borrower who is stuck with the loan – or the lasting consequences of foreclosing.
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What's your money personality? Do any of these styles describe you: Careful Caretaker, Impulsive Competitor, Logical Problem Solver? If so, tell us why for an upcoming feature in Money magazine. E-mail Judy Feldman at firstname.lastname@example.org.