Falling Into the Subprime Trap

Mortgage lenders like Novastar (NYSE: NFI  ) and New Century (NYSE: NEW  ) , which cater to customers with less-than-perfect credit, have recently seen their shares get slammed. After years of hyperactivity in the housing market, the business of lending money is finally slowing down, at least in the subprime arena.

Unfortunately, much of the damage to the subprime mortgage business is because of many borrowers' increasingly dire situation. To buy homes in pricey real estate markets, these borrowers were willing to take on immensely risky mortgages. As interest rates rose, more borrowers found themselves facing higher payments, resulting in increased delinquency and default rates. While the situation has hurt earnings in the sector, borrowers have it even worse; they may not only lose their homes, but also damage what's left of their credit ratings.

How did this happen?
You'd expect that mortgage lenders would be looking out for their own best interests by avoiding customers who couldn't make their payments. However, most lenders' attempts to resell their subprime loans have made it much less important for them to evaluate borrowers diligently. By reselling the loan, the lender not only rids itself of a potentially dangerous asset, but also earns an immediate profit from one-time fee income. As long as borrowers could repay the loans, everyone benefited. However, once borrowers' finances were stretched beyond their limits, the financial institutions that bought these loans were left holding the bag.

Higher delinquency rates have forced the institutions that buy subprime loans to change their tactics. Last week, Freddie Mac (NYSE: FRE  ) announced that it will stop buying many subprime mortgages, and it's likely that other financial institutions will follow suit. This will force subprime lenders to either tighten their lending standards or assume the higher risk of keeping these loans on their own books.

How borrowers should respond
These lessons may be painful for borrowers, but they're a natural consequence of unwise decisions. Too many borrowers paid attention only to the amount of their monthly payments, without any concern for more important loan terms, such as interest rates or payments toward the principal balance. Skyrocketing home prices forced prospective buyers to choose between accepting loan terms that would ultimately prove unsustainable, or entirely abandoning their hopes for homeownership. Faced with this dilemma, and having seen friends and neighbors saved from similar bad loans by the appreciation in their property values, many chose to roll the dice.

If any good comes from the bursting of the housing bubble, it will be that homeowners and borrowers may act more responsibly about buying property and taking on mortgage debt. Buying a home is a dream for many, but it takes hard work and determination to save enough to afford it. While products like negative amortization and interest-only loans offer an alluring shortcut, borrowers may now think twice before making a decision that could come back to haunt them.

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The Fool has several resources for current and aspiring homeowners. The Home Center has detailed information about every stage of the process, while our Credit Center can teach you about effective credit management techniques that will keep you out of trouble. If you'd rather get help putting it all together, check out Motley Fool Green Light, the Fool's personal finance newsletter. Discover all its useful advice with a free 30-day trial.

Fool contributor Dan Caplinger is buying a house, but he's sticking with a nice, traditional fixed-rate mortgage. He doesn't own shares of the companies mentioned in this article. The Fool's disclosure policy won't leave you out in the cold.


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