Good credit can't protect borrowers from bad loans

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NEW YORK (CNNMoney.com) -- A good credit score doesn't mean you can't end up in foreclosure.

Many now troubled borrowers had excellent credit when they got their mortgages. But they took out loans that they couldn't afford to buy homes that were too expensive. Credit scores alone are no guarantee that borrowers will be able to keep up with their payments.

In September 2007, the most recent month for which data is available, more than 20% of subprime mortgage borrowers with nearly perfect scores of between 840 and 850 were 60 days or more delinquent, according to First American LoanPerformance. (See correction, below.) That default rate was roughly equal to that of borrowers with much lower scores, in the 540 to 599 range.

Take Trish Phillips, an office manager for an AM radio station in Florida, who bought her Ft. Lauderdale home in early 2007. She had a FICO score of 780 and a very stable work history, with 14 years at the same job. Less than a year later, however, she was in danger of losing her home.

"We used FICO scores as a huge determinant for [loan] performance, but it doesn't always work that way," said Richard Bitner, a former subprime mortgage broker and author of "Greed, Fraud & Ignorance: A Subprime Insider's Look at the Mortgage Collapse."

The problem, he explained, is that underwriters failed to take other risk factors into account, such as income, the down payment, and total household debts.

In the runup to the bubble, underwriting standards eroded just as much for people with high FICO scores as they did for people with bad credit, said Bitner.

For Phillips, the problem was the she ended up with an exotic loan called an option adjustable rate mortgage (ARM). With these loans, a borrower has the option of making minimum monthly payments that don't even cover the loan's interest. That unpaid interest is then added to the mortgage principal, which means that the loan grows bigger - and more expensive - each month.

"These loans required borrowers to have FICO scores of 700 or better to get them in the first place," said Phillips' foreclosure prevention counselor, Michael Sichenzia, of Dynamic Consulting Enterprises. "But they are defaulting at a high rate."

These loans were very profitable for brokers and lenders, who peddled them to borrowers aggressively. What's worse, loan officers used the option ARM's minimum payment to determine whether a borrower had sufficient income and assets to carry the loan, rather than the full monthly payments. That ensured the loans would get written - and nearly guaranteed that payments would become unmanageable.

Home buyers were also complicit, turning to option ARMs and other dicey loans to buy homes more expensive than they could really afford.

Trish Phillips had enough income to pay about $1,300, perhaps $1,400 a month for her home, which cost $279,900. The minimum payment on her option ARM was $1,276, but she was incurring interest of more than $2,000 a month. The difference of about $800 was added to her mortgage balance every month.

Option ARMs have what's called a negative amortization cap. If the unpaid interest accrues to as little 10% of the original principal (that varies from loan to loan), the loan reverts to a traditional mortgage, where the borrow must make full monthly payments that pay down the loan's principle.

According to Phillips, who was making the minimum payments, that meant her monthly bill would jump to $2,300 after just a couple of years and then to more than $3,000 a year after that She knew she couldn't afford it and went for help.

Phillips admits that she didn't clearly understand the loan terms before she closed on the house and says her mortgage broker didn't explain them. She had misgivings but, "I was afraid of losing the down payment," she said.

Home owners found themselves in this situation all over the nation - especially in pricey areas where many home buyers couldn't afford to get on the real estate merry-go-round without resorting to exotic loans, such as option ARMs or 2/28 hybrid ARMs. The latter feature two years of low, fixed, introductory interest rates. After that, they reset much higher and adjust every six months or so.

"When ARM rates were so low - 3.5%, 4% - many people, some with very high FICO scores, used them to buy houses they couldn't have afforded at 6%," said Steve Habetz, a mortgage broker in Connecticut. Home prices had run so far ahead of income that even well-paid borrowers had to stretch to buy homes.

"They anticipated home prices rising, or that they would get pay raises etc.," said Habetz. When that didn't happen, they were stuck in unaffordable loans.

"There were also a lot of unqualified loan originators and little government oversight," he said. "You had many mortgage brokers who took the path of least resistance - or the most profitable one. The elderly and minorities were often put in loans that didn't make any sense."

Borrowers were often told they could simply refinance before their mortgage rate reset using the home equity they'd accumulate as home prices rose. But of course, prices went down instead.

As for Phillips, she managed to get her loan modified, with Sichenzia's help. Her payment is now frozen for three years at $1,281 a month and her balance will not increase during that time. She hopes to refinance into a fixed rate loan before those three years are up.

And, since she succeeded in getting her mortgage modified before she even fell behind on her payments, her FICO score is still a healthy 775.

Correction: An earlier version of this story incorrectly stated that the First American LoanPerformance report looked at subprime mortgage borrowers with credit scores of between 840 and 900. The scores ranged from 840 to 850.