Understanding the complexities of subprime mortgages and ARMs is crucial as they play a significant role in the current foreclosure crisis sweeping the nation. This article delves into the mechanics of these financial instruments, their impact on the housing market, and the broader economic implications.
Subprime mortgages, designed for borrowers with lower credit scores, have significantly contributed to the increase in home loan defaults. Initially, these loans were a small fraction of the market, with only 8% of total originations in 2003. However, by 2005 and 2006, they surged to represent 20% of all new mortgages (Federal Reserve).
Adjustable Rate Mortgages (ARMs) are another product that has seen widespread use and subsequent scrutiny. These loans offer initial lower rates that reset at higher rates after a predetermined period. The most common types were the 2/28 and 3/27 ARMs, which constituted 60% of all subprime mortgages issued in 2006.
The foreclosure crisis has not only affected low-income areas but also wealthier neighborhoods. For instance, in Sacramento, CA, delinquencies on subprime loans of 60 days or more reached 14.1% in December 2006 (Wall Street Journal). The cost of foreclosure per property ranges between $40,000 to $50,000, with lenders reporting losses up to 50 cents on the dollar.
Consider a $200,000 loan comparison between a fixed 30-year rate at 7.5% and a 2/28 ARM starting at 7% which then adjusts to higher rates. The fixed-rate mortgage remains constant at $1,598 per month, whereas the ARM payment increases from $1,531 in the first two years to $2,370 by the fifth year, assuming a 2% rate increase in year five.
The subprime mortgage and ARM issues have created a significant financial strain on many American families. The rolling up and securitization of these mortgages have exacerbated the problem, leading to a broader economic impact, including the credit crunch that former Federal Reserve Chairman Ben Bernanke addressed through policy adjustments. Moving forward, it is crucial for both lenders and borrowers to fully understand the risks associated with these financial products to prevent a recurrence of such a crisis.
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