Bad Credit Loans: How Did Even Smart Businesspeople Get Into So Much Trouble?
By Gina PogolMortgage Credit Problems Columnist
Earnest Asks: Dear Gina, I was talking to a friend at a dinner party and he mentioned that he trapped himself into a bad credit loan he can't get out of. He's a financial planner. Several others joined the conversation, including a number of educated professionals, and many admitted to similar mistakes. How did this happen to smart people like that and how do "Average Joes" protect themselves when even savvy folks messed up? - Ernest in Washington
Gina Says: Hi Earnest, That's a great question. The reason so many "smart people" got caught in the sub-prime, bad credit, or Alt-A loan mess was that they relied on continuous property appreciation. In America it's a home-spun truth that real estate is a sure investment: it's tangible, you can live in it, and in fact many, many famous families have made fortunes in real estate.
Another temptation of investing in real estate is leverage--that is, unlike many investments, you can buy the whole shebang without putting a lot of your own cash into it. So if you buy a $100,000 house, put $10,000 down, and in a year it's worth $110,000, you just doubled your investment (to keep things simple we'll assume that your home ownership costs after taxes didn't exceed what you would have paid to rent for that year).
So people who either were fairly educated investors, or thought they were, leveraged their homes to the hilt. They put almost nothing down, chose mortgages with very small initial payments, and invested the difference in the stock market or other places. They bought rentals with loans that didn't require proof of their ability to repay them. Others, seeing the values climb so fast, panicked and rushed to buy whatever they could get even if it took an expensive Alt-A or bad credit mortgage to do it--before they got priced out of the market.
And the tax benefits were excellent and the property values climbed and the money flowed....until it didn't.
One problem with most of these loans is they were never meant to be permanent financing solutions--only to provide short-term cash-flow, get a family into a home and give them a chance to clean up their credit history, or allow people to move into houses they'd be able to afford later when they earned more. In fact, one nickname for loans like this is "band-aid loan" because it's not supposed to stick to you that long.
Had home values, stock markets, and jobs remained stable, these people would have come out looking very smart. And rich. But aggressive investing is a double-edged sword and the unthinkable happened. And then the "smart investors" were stuck with payments shooting through the attic, equity dropping through the basement, an uncertain economy where their jobs were suddenly at risk, valuable stocks turned into worthless junk, and lenders unwilling to put more money on the line.
Not a happy ending.
So we try a new story: Average Joe protects himself by adopting a more conservative approach. The old put-six-months-of expenses-in-a-safe-place, keep your mortgage payments below 31% of your income, save all you can, and spend less than you make strategy. And markets will recover, and markets will tank again. And Average Joe will be safe and sound.
The end.
About the Author
Gina Pogol has over a decade of mortgage lending experience, in addition to practice as a paralegal for a bankruptcy attorney, and as a business credit consultant for Experian. She is also certified to underwrite Fannie Mae loans. She earned her BS in Financial Management from the University of Nevada.
All information provided “as is” for informational purposes only, and is not financial advice. MortgageCreditProblems.com, its affiliates, and any of the independent providers of information on this site shall have no liability for any informational errors or incompleteness, or for any actions taken in reliance on information contained herein.
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