Neg Am

Posted: June 26, 2007 in Finance

The troubles in the sub prime lending industry in the US have made headlines around the world. In simple terms a lot of lenders found themselves with too much cash on their hands and not enough people to borrow it. Their solution was to lower their standards to the extent that almost anybody could qualify for a mortgage.

I’m sure at the time is seemed like a good idea. These less qualified borrowers get charged a higher rate to compensate the lenders for the higher risk. In a rising housing market the homes that these mortgages are secured against have probably risen in value and can be sold for enough to clear the mortgages should the borrower default. It’s a Win-Win situation.

Until the market stops going up. When that happens all bets are off. The number of defaulting borrowers goes up. The back door of foreclosure is no longer as reliable as it once was. Lenders can no longer pay their investors. Companies that were the long the darlings of Wall St. find themselves as bankrupt as the borrowers that they coaxed into unsuitable loans.

Let’s be clear, the Sub Prime woes have been caused by little more than greed. When lenders had scraped the bottom of the barrel to find borrowers, they kept going, digging a hole under the barrel to find even more borrowers who could only afford mortages with artificially low initial payments. In some cases the payments were so low they didn’t even cover the interest. Each month the borrower owed more than the last.

This was the case with Denith Harrigan, a disabled veteran on a fixed income of $2100 a month. He was offered the change to refinance his existing mortgage at the low low rate of 1%. It would give him the chance to pay off credit card debts and fix his pool.

What Harrigan claims he didn’t understand was that in less than three years, his payment could grow to equal his total income. Yes, it may be difficult to comprehend this but people really do fall for the 1% mortgage scam. They really do believe that the rate and the repayments will always stay that low.

I can say from first hand experience that “some” mortgage brokers are not anxious to correct any wrong ideas that the prospective borrower might have. When we were shopping around for a mortgage one broker offered a so called “Negative Amortisation” mortgage. It was the classic 1% pitch.

The quotation looked very good, the monthly repayment was exactly what it would have been if my mortgage rate was 1%. If you plugged the details into any mortgage calculator it confirmed the figures.

What the quotation didn’t explain that the other 7% interest that I was being charged wasn’t being paid by my monthly repayment, it was getting added month after month onto the principal. In simple terms I was going back each month are borrowing more and more money.

I played along for a little while pretending to be dumb to see if the broker would highlight that the 1% rate was more of an illusion than a reality, and that although I wasn’t writing a cheque each month for the full amount, I was most definitely getting charged the full amount. He didn’t. It was only when I asked direct questions that I already knew the answer to that I got the real facts.

If you know enough to ask those questions then you probably don’t need to even ask them. The vunerable borrowers are the ones who look at a quote and a monthly repayment and don’t realise that the rate and the repayments automatically increase.

And to be fair to these people, I only started asking questions because I knew that no mortgage lender could lend money at a rate of 1%. What percentage of the population do you think understand enough to know at a glance that an interest rate is too low to make sense?

Harrigan should have known better. According to newspaper coverage he earned a real estate license in 2003 and has studied accounting. Now I know a real estate license is hardly difficult to get, and they didn’t say he qualified as an accountant. So it’s hardly a ringing endorsement.

It does open up the possibility that Harrigan new what he was getting into. The industry has screwed so many people with these mortgages that government are sitting up and taking notice. Governer of Florida Charlie Christ has signed a bill required brokers and lenders to explain the loans more clearly.

When everyone starts accepting that the people who got into these loans were victims it becomes a little easier for those who knew what they were doing to also claim to be victims.

These “Neg Am” mortgages were widely used by investors hoping to flip properties. They were used by some homeowners who wanted to clear credit card debts, and who believed the Negative Amortisation would be offset by ever increasing property prices.

Harrigan managed to clear his credit card debt, fix his pool and at the same time lower his monthly repayment. Was he a victim? I don’t know.

It’s hard to tell which group a particular borrower falls into, and given the predatory and dishonest practices of the US lending industry it’s probably safer on average to give the benefit of the doubt to the borrower.

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1% mortgage – from joy to time bomb

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