Subprime Fix

skeeter1

The Problem:

Your mortgage has interest. In the beginning 15+ years of a mortgage, almost all of the payments go towards interest. It's very hard to build "equity" in a house fast. Your house can appreciate if the market is rising. The average appreciation is usually 5% a year (these past 4 years have been crazy). But, now that the real estate market is going down, the "equity" is now likely gone. Since most of your payments have gone to interest, you haven't put much of a dent in the mortgage balance. Yet, you've paid the bank thousands & thousands of dollars. Now, the bank is crying poor becuase so many people are going bad on their loans. Yet, they collected lots of your money in interest.

Skeeter's Solution.

Why can't the mortgage interest work like a simple interest loan? If it did, much, much, much more of your mortgage payment would go towards the principal in the early years. You'd be able to own your house free & clear in fewer years - and you'd pay alot less in interest over time. We wouldn't be in this fix, and more people would own a house free & clear. The banks would not be as rich, but would still do good.

Why not Skeeter's Solution?

The Golden Rule. He who has the gold makes the rules. In this case, it's the lending industry that has the gold that has made the rule that home mortgage interest should be charged "up front" - denying people the opportunity to own their own home, free & clear.

How many of us own our house, free & clear? I don't.

Skeeter

Gopher

In the olden days, people used to be required to save up 10% or 20% of the cost of the home. It was called a "down payment". Those words aren't in the vocabulary of many home-buyers these days.

It could be that the mean cost of houses has gone up so much (compared to like $50,000 when our parents bought their homes) that it's harder to come up with a down payment.

So the mortgage companies and banks loosened their restrictions and it became easy to get a "zero down" mortgage.

Since 2005 house values have held steady or even declined in some markets, meaning zero-down buyers who ran into financial problems could not count on appreciation to be able to break even or come out a little ahead.

Hence the increase in foreclosures and quick sales in lieu of mortage.

It's been really hard to sell a house lately. Buyers can get what they want and almost name their price.

skeeter1

But, putting 20% down on a house still doesn't help if the market goes down by 40%.

Buy the house:

House price: 200,000

20% Downpayment $40,000

Mortgage $160,000

Equity $40,000

After 5 years:

Interest paid (assume 5%) under current mortgage plan: Appx $40,000

Mortgage Balance: $150,000

Your house value due to market declines 40% (due to the other people doing "short sales" and foreclosures)(.60 * 200,000) : $120,000

Your now upside down in your house value!

But if you had a "simple interest" mortgage....wouldn't it be better as more of your payment would have gone to principal?

skeeter1

The problem is that we're all paying mortgage interest or "compound interest" instead of "simple interest".

skeeter1

http://michaelbluejay.com/house/compoundinterest.html

Gopher

The housing market over a longer period of time trends upwards. True the market has gone down for a while, in correction to the overheating that occurred from 2000 to 2005. I doubt it will ever go down 40%. The percentages of decline are nowhere near that figure (in spite of the high number of foreclosures and quick sales that are happening in the market).

The system as it is structured rewards those who truly are in the home for a longer time, because as time goes on much more of the payment is actually for the principal. So it is an incentive to buy the home as a long-term investment.

Also in the meantime, there is the mortgage-interest tax deduction to help ease the burden on the homeowners. So there are reasons for the standard way loans are amortized (more interest up front, less later).

I'm not an economist, but I wonder if a radical change from current amortization to simple interest were made, would the banks be able to stay in the mortgage-lending business without raising their interest rates?

Marvin Shilmer

Skeeter,

Your solution is untenable.

Investors agreeing to tie money up for long periods (such as mortgage loans) deserve compound interest every bit as much as I deserve compound interest for money I invest for long periods (such as retirement savings). I want to earn interest on my interest. Why would I then deny this return to another investor?

In a manner of speaking, my retirement investment is partly funded by my mortgage payments. This is particularly true if any of my retirement savings is invested in a financial market making gains contributed to by my mortgage payments.

Why would anyone expect an investor to simply give away earnings on interest? Such a circumstance would deny the power of retirement savings in, for example, a typical 401K plan.

The practical solution to avoid future lending crises is the same as it has always been. Avoid questionable lending and reckless borrowing. Investors can act prudently by keeping a closer eye on how their money is being used, and the risks associated with that use. As for principal on a mortgage, whittling down the principal is as simple as paying principal on top of whatever is the monthly minimum payment (which already includes a little principal).

Call me old school, but in my book good money management demands resolving borrowed money as soon as possible, and living within whatever is my means. No matter how you stack it up, money is a very expensive thing to buy, and this is precisely what a person is doing when they take on a mortgage.

Marvin Shilmer

moshe

Much of the money banks loan out is created out of thin air. The Federal Reserve regulations allows banks to loan out more money than they have in deposit.

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a definition from howstuffworks:

Banks create money in the economy by making loans. The amount of money that banks can lend is directly affected by the reserve requirement set by the Federal Reserve. The reserve requirement is currently 3 percent to 10 percent of a bank's total deposits. This amount can be held either in cash on hand or in the bank's reserve account with the Fed. To see how this affects the economy, think about it like this. When a bank gets a deposit of $100, assuming a reserve requirement of 10 percent, the bank can then lend out $90. That $90 goes back into the economy, purchasing goods or services, and usually ends up deposited in another bank. That bank can then lend out $81 of that $90 deposit, and that $81 goes into the economy to purchase goods or services and ultimately is deposited into another bank that proceeds to lend out a percentage of it.

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Let's say you put $10,000 into your checking account and they used it as reserves to back a mortgage. They pay you 3% - $30 a month in interest. Your bank makes a loan of $100,000 using your money for the reserve requirements. 7% mortgage on $100,000 = around $650 in interest the first month minus the $30 paid to you= about $620 interest = over $7000/yr in interest. You only got $360 in interest from the bank for the whole year. That gives the bank a gross interest rate of over 70%/yr on your $10,000 deposit! It all seems like a criminal enterprise, but our laws say it is all legal. I won't go into how the Federal Reserve creates the money in the first place, it might ruin your sleep.

skeeter1

Marvin,

I agree with you.

After thinking about it, it's the real estate brokers who are making the money. They sold the houses super high (great commissions). They used "certain appraisers" to give super high appraisals. They recommended people to "certain banks" with mortgage brokers who made more commissions on these adjustable mortgages. The real estate brokers, appraisers, and mortgage brokers/banks were all in "kahoots". This drove up the market. Plus, we have alot of foreigners who buy houses here, and they liked it when the dollar was cheap & weather was fair. Today, our local paper admitted that the actions of the real estate & appraisal industry helped to create this problem. Now, that there is a bust...the brokers are the first to try to buy the short sales & foreclosures. They know about it first. Talk about sharks.

I am doing ok, and able to make my house payments. But, so many people around me are not. There are foreclosures after foreclosures where I live. On some streets, even very wealthy ones, over 1/2 of the houses are for sale. The market prices are so unstable, that it's nearly impossible to get an appraisal a bank will trust. The banks are using their own appraisers, and many, many loans are not going through. We have an entire town in our area that some mortgage companies will not write any loans to.....

While interest & subprime lending are partly to blame, another major culprit is the insurance & taxes. Both have doubled in the past year. On a $200,000 house, expect insurance to be $3,500 and taxes to be $4,000. The increased taxes, insurance, and interest are killing this economy.

Something has to be done. Perhaps it's nationalizing natural disaster insurance? Perhaps it's just waiting this storm out.

Skeeter

5go

The practical solution to avoid future lending crises is the same as it has always been. Avoid questionable lending and reckless borrowing. Investors can act prudently by keeping a closer eye on how their money is being used, and the risks associated with that use. As for principal on a mortgage, whittling down the principal is as simple as paying principal on top of whatever is the monthly minimum payment (which already includes a little principal).

Reckless burrowing can only be stopped by ceasing reckless lending. That is why we are in trouble banks are lending to people they know are risky. Now your retirement is going to hell because some idiot risked your money on some ~~sucker~~ one who can't pay to get a higher interst rate and also in the case of the salemen get a higher commission on the sale of the loan.

Subprime Fix

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