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Buying a Home: A Comparison Between Lending Before, and What it is Today

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The financial crisis of 2007-2008 served as a huge inflection point for the behavior of both homebuyers and lenders.  Prior to the crisis, in the 1990s until 2006, Americans witnessed the easy money lending days.  These were the days when homebuyers were allowed to obtain mortgage loans without any documentation required to verify income.  Loans requiring very little documentation to support the applicant’s financial picture were being given frequently.  Sub-prime loans became the norm.  The name “sub-prime” itself indicates the high risk associated, as it is a different way of saying “less-than-perfect”.  Andrew Lo, Author of “Reading About the Financial Crisis: a 21-Book Review” stated that, “historically, this group [subprime borrowers] was defined as borrowers with FICO scores below 640, although this has varied over time and circumstances, making it harder to determine what “subprime” really means”.  On top of that, subprime borrowers were given “less than prime” interest rates in comparison to “prime” borrowers.  Adjustable rate mortgages were also popular at the time because borrowers who normally would not be able to qualify for a mortgage would be able to get in with a very low interest rate.  Eventually rates adjusted to the market rate thus making it unaffordable and difficult for these borrowers.  The combination of high interest rates, less-than-perfect credit, adjustable mortgage rates, and unverified income information went well for a period of time until it eventually collapsed.  The collapse led to drastic shifts that we observe in the industry now.

Before the crisis, homebuyers would put very little down in order to purchase a house – along the lines of 3% down if any at all.  This in itself was a red flag.  Part of the process is saving for a home for a long time before the actual purchase, as this shows homebuyers the significance of such a large investment that takes preparation, hard work, and attention.  By considerably lowering the barrier to entry, homebuyers were placed under the impression that a home was as simple to keep as it was to attain, and thus owning a home became more of a right than a privilege.  As we find ourselves in the aftermath of the crises, homebuyers must typically put down 10%-20% on primary homes and 20%+ down on investment properties.  Not only does this create a barrier of entry, but also it lets only those through who have demonstrated that they are serious about owning a home and the responsibility that comes with it thereafter.   The return of the barrier to entry is also a return of a norm of lending standards.

For a certain period of time, these high-risk borrowers were paying back the loans because the real estate market was doing well.  This proliferated the amount of lenders making high-risk loans to unqualified borrowers – until the real estate market suddenly wasn’t doing so well.  Prior to the 16 years before the financial crisis, annual returns on mortgages were around 1%-3% as an industry average.  These returns were consistent between the 1950s and the 1980s according to Fox Business.    Throughout the 90s-2006, return on investment hiked up to 10% averages.  The industry was booming.  Buyers were flipping homes throughout the country.  Everyone was making money until rates went up and home values didn’t.  When that happened, a lot of homeowners defaulted on their loans at once, and a lot of investors tried to sell their loans at once—leading to a financial collision.

When everyone was getting a good return on their investment, everyone was happy –banks pushed this activity, and Washington supported it.  It was all fun and games until it hurt everyone involved.  The most important thing, however, is not necessarily who is to blame but how we can make sure that we never repeat history.  On July 21st, 2010, President Barack Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act into federal law.  A very crucial part of the Dodd-Frank Act, Title XIV the Mortgage Reform and Anti-Predatory Lending Act was set so that the financial crisis could not be replicated.  Subtitle A of Title XIV – Residential Mortgage Loan Origination Standards require that “the mortgage originator must verify the consumer’s ability to pay.  A violation of the ‘ability to repay’ standard, or a mortgage that has excessive fees or abusive terms, may be raised as a foreclosure defense by a borrower against a lender without regard to any statute of limitations”.  The Dodd-Frank Act clearly outlines guidelines that protect borrowers from this type of predatory lending, and calls for thorough and proper verification to assess each borrower’s ability to repay the loan.

Looking back on such a monumental mistake, it is appropriate that lenders are taking the initiative to raise the bar and be incredibly careful about who gets a mortgage these days.  For borrowers, the industry has revived the notion that borrowers must have to have good credit, strong employment history, and money for a down payment in order to purchase a home and see it through to the end.  Lenders now require an extensive verification process to ensure that the home will not be flipped.  The current extensive and sometimes stringent process of obtaining a home loan is all a protective measure so that things do not get out of hand once more.

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