What can we learn from the US Sub Prime Mortgage Collapse?

Recent problems in the American sub prime mortgage industry are well documented. It is causing a record number of home repossessions and is illustrating the inadequacy of proper checks in this section of the market. What can we learn from the problems in the sub prime market?

1. Never trust a mortgage salesman.

What is clear from the fallout from the sub prime mortgage industry is that mortgage companies encouraged very aggressive sales techniques. Salesman, paid on a commission basis, had an incentive to sell as many mortgage products as possible. The salesman focus is on selling mortgage deals at any cost, they were not always concerned with the long term affordability. Therefore, there are several cases of people being sold mortgage they quite literally could not afford. For example, this mortgage example, shows how one vulnerable old lady was sold a mortgage where after 2 years the payments would be higher than her total income! see: dangers of sub prime mortgages. Of course, these examples, are not true of the whole industry. But, it also true they were not isolated cases. It would be unfair to put all the blame on the salesmen.; the sub prime mortgage firms themselves have to take responsibility for encouraging this kind of aggressive sales techniques. It is also unfortunate, that these sales techniques have given a bad reputation to the whole mortgage industry.

2. Be wary of Special introductory 2 Year Deals.

The secret of selling many sub prime mortgage deals was an attractive introductory period, with a significant discount on the base rate. This meant the product could be sold with emphasis on the first 2 years heavy discount. However, the real cost of the mortgage, which occurred at the end of this period, was usually hidden in small print. It is very important to be clear on all the costs and changes to the interest rate. If in doubt, go through an independent mortgage adviser.

3. Look out for your Relatives.

These pieces of advice may seem like common sense to those of us who take an interest in financial matters. But, would all your relatives see through the small print and the attractive 2 year deals? The problem is that, if our relatives, grandparents or children make a mistake, we often feel obliged to help solve the mess. Therefore, it is worth taking time to review any new mortgage deal, loan deal that they take it out. It is a bit of hassle to mix in their affairs. But, it is much less hassle than having to pick up the pieces when the house is repossessed.

4. No Bubble lasts for Ever.

American house prices were driven partly by economic factors, but also by a speculative bubble. To many, rising house prices were evidence that they would continue to rise forever. Many of the sub prime mortgages were lent against a backdrop of confidence and optimistic expectations. However, as we know history repeats itself. Bubbles come and bubbles get burst. When taking out a mortgage, we should always bear in mind that house prices can go up as well as down. Any financial decision should not be based on an assumption that the asset bubble will continue to occur. Again most of the blame can be placed on the mortgage companies who allowed a significant part of their mortgage lending to be based on optimistic housing market forecasts. see: Why the Roof fell in on the US Housing Market

5. It is hard to predict Interest Rates.

A few years ago US interest rates were at an all time low. People talked about a new low inflationary paradigm. The argument was that because of globalisation and cheap imports from China, inflation was a thing of the past. Because of the low inflation, it could also be assumed that interest rates would remain low. However, inflation has started to creep up; even Chinese goods are starting to become more expensive. As a consequence interest rates have increased by more than many expected. This rise in interest rates has often been the cause of the record rise in mortgage defaults. Fixed interest rates can insulate us to some extent. But, as it is often said, we should be aware of how much our mortgage payments will increase if interest rates do change. see: How easy is it to predict interest rates?

6. The importance of the Housing market on the economy.

The jury is still out on whether the sub prime problems will cause a recession in the US economy. However, it is already clear that the rise in defaults and fall in US house prices have had a significant impact on consumer confidence, stock markets and the wider economy. As the biggest form of consumer wealth, housing exerts a significant influence over people’s economic outlook. A fall in house prices (or even just slow down in growth) can undermine consumer confidence. Mortgage equity falls and this leads to lower consumer spending and growth. The crisis has also had an impact on stock markets around the world.

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