What Went Wrong in the Mortgage Industry

We have all heard about ARMs - Adjustable Rate Mortgages and Interest Only Mortgages and Balloon Mortgages, but how did this debacle start? In 1929 the Glass-Steagall Act was passed to prohibit banks from accepting both deposits and underwriting securities. In 1999, the Gramm-Leach-Bliley Act was passed which effectively repealed this separation for many large financial institutions.

Investment banks had previously assisted lenders in raising more lending funds. They had the ability to offer longer-term fixed interest rates by converting loans into bonds. The banks would make house loans in the form of a mortgage, and then use the investment bank to sell bonds to fund the debt. The money from the sale of the bonds can be used to make new loans. This is called securitization. The banks began to securitize loans themselves, and the investment banks also became lenders.

Since money is made from the process of selling mortgages, lenders made it easier for borrowers to assume higher priced houses by offering adjustable rate mortgages and interest rate only payments. Since the housing prices were rising so rapidly, they believed the owners would be able to quickly refinance at more favorable terms.

Housing prices started to drop during 2006 and 2007 which made refinancing more difficult. The borrowers may have also assumed that their income would grow more rapidly than it did. So then the people who were given these risky loans with the idea that they could refinance them were now stuck with mortgages that they could not afford.

I know a family that was talked into buying more house than they could afford by the real estate agent. Realtors will tell you that you will save money on taxes, so you can afford to pay more on a mortgage than what you are paying for rent. The only way you would have more money every month to pay towards your mortgage is if you can change your withholding, because you know that you will be able to itemize your taxes and not owe money at the end of the year.

Your housing expense should not exceed 28 percent of your monthly gross income. Anything higher than that, and you will not have any discretionary income.

When shopping for a mortgage, your debt-to-income ratio should be no higher than 36 percent. In order to calculate your debt-to-income ratio, add up your fixed monthly expenses such as car payments, minimum credit card payments and other regular debt obligations like child support or loans. You do not have to include groceries or utilities. Add your expected housing payments which will include homeowner’s insurance and property taxes, and divide the total by your gross monthly income.

Some lenders allow for a debt-to-income ratio as high as 41 percent, but will you be able to buy groceries and enjoy life? After all, don’t forget about the other things you buy throughout the year. What about money for clothes, school supplies for children, and fees for your child to participate in sports? What if you want to join the gym? A budget that shows everything you spend will help you see the big picture of what you can really afford. It will show if there will be any discretionary spending money left.