There’s a term called “common sense underwriting” in the mortgage industry. It means that lenders should only approve loans that make sense from a risk standpoint. If a borrower is more risky, they need to compensate lenders for this risk by providing more proof of their ability to pay. If a borrower is less risky, they will be approved more easily and get lower rates.
In light of the subprime mortgage market troubles, the common sense underwriting credo has been called into question. Many lenders have closed their doors recently because they lacked common sense and approved overly risky loans. This quarter, we will discuss whether the subprime fate will extend further, and how all of this will affect you.
Irrational Lending Exuberance
As the internet boom kicked off in 1996, then Fed chairman Alan Greenspan famously cautioned against “irrational exuberance.” Stock markets largely ignored his warning for four years and ran up to record highs before crashing in 2000. After that, the Fed had to cut rates to re-stimulate the stalled economy, causing a new wave of exuberance in housing. Just like the inexperienced dot-com companies before them, inexperienced lenders cropped up everywhere to sell low rates on home loans.
Many of these lenders were so quick to approve loans, they did so without common sense and without the risk controls lenders have been developing over two decades since the S&L crisis. As home prices have corrected over the past several quarters, we’re seeing these new lenders shake out just like the dot-coms shook out in 2000-2003.
If you’re someone with low credit, low income, and no money saved, then loan approvals will probably be more difficult for you. If you’re someone with any one of these characteristics, you’ll probably be OK.
100% Financing Is Limited, Endangered
For example, maybe you just relocated and missed a utility bill which took your credit score down to 630. Yet you have $50,000 saved up, a $150,000 household income, and the same job for five years. As long as you’re with an experienced lender or broker, common sense underwriting will recognize that your overall profile still makes you a good credit risk, and you should end up with a good deal.
In another example, maybe you have a 720 credit score, a $150,000 income, the same job for five years, but you have no savings for a down payment. Relative to even three months ago, your choices are going to be significantly more limited. There are still 100% financing options, but most Wall Street firms have stopped buying these loans from lenders. This means lenders wanting to make these loans must carrying them on their books, so underwriting guidelines are stricter and rates are higher.
The Market Knows Best
High-profile internet companies disappeared and new laws were passed after the dot-com boom, so it’s not unreasonable to think we’ll see more mortgage companies suffer and more Congressional hearings as the housing boom unwinds. It’s all part of a normal market cycle. In the housing boom, there were quick-buck lenders that thought they could subvert or redefine the market. But they are being rooted out because the market only allows for risk-conscious, common sense practices over the long term.
So as you shop for your next loan, make sure your mortgage consultant is experienced and understands your time horizons, budgeting and investment goals. And make sure your lender is an established player that has seen full market cycles.