In the wake of the devastating housing crash of the late aughts—and the Great Recession it helped trigger—protections were put in place. Bad mortgages were scuttled. Lenders became far choosier on who could qualify for loans. Laws were passed to ensure the world’s economy would never melt down once again due to dangerous lending.
However, today fears are mounting that riskier lending could be staging a comeback.
As home prices hit record highs each month and mortgage interest rates are rapidly rising, some loan officers have begun loosening their lending standards—albeit a little—to get more mortgages into the pipeline. Some buyers might be overextending themselves financially in their desperation to win bidding wars. And more borrowers are choosing mortgages that start out cheap, but can become more expensive over time, in an uncomfortable echo of the run-up to the financial crisis.
That’s left many questioning just how solid mortgage lending, which was one of the primary causes of the last housing bust, is this time around. It’s an especially pointed concern as fears of another recession are growing. And while most real estate and lending professionals do not believe these circumstances could lead to another crash or foreclosure crisis, that doesn’t fully allay their concerns.
“Lending standards in today’s housing market are day and night compared to the mid-2000s housing boom, in part because of the regulation put in place following the market crash,” says Ali Wolf, chief economist of building consultancy Zonda. “While there are stronger lending rules in place, the combination of rising home prices, rising mortgage interest rates, and rising inflation are straining today’s home shoppers. Anecdotally, we are hearing from some loan officers that homebuyers are starting to stretch just to be able to secure a home.”
Homebuyers today are grappling with mortgage payments that are about 50% more per month than they would have been just a year ago—for the same house. That’s a substantial hike, especially considering home prices had risen significantly last year as well, due to the double whammy of higher home prices and mortgage rates.
Some buyers have responded by pushing their budgets to the outer limits. That can be dangerous if buyers aren’t leaving themselves a cushion for rising costs, savings for emergencies, as well some extra cash for going out or taking a vacation. It’s also coming at a time when inflation is pushing the cost of necessities, everything from a gallon of milk to a gallon of gas, ever higher.
More borrowers are now considering adjustable-rate mortgages, or ARMs. The loans initially offer cheaper payments that can later increase—a risk that is causing some PTSD for those who don’t want a repeat of the Great Recession. About 8.2% of all mortgage applications were for ARMs in the week ending June 3, according to the Mortgage Bankers Association, an industry group. That’s compared with just 3.9% in the week ending June 4, 2021.
“Anytime people are looking at adjustable-rate mortgages … there’s risk,” says Sarah Mancini, staff attorney at the National Consumer Law Center. “Most people’s income doesn’t fluctuate with interest rates. … [And] people are not good at reading these very complicated [lending] documents.”
In addition, rising mortgage rates have left lenders scrambling to find new business. Fewer buyers can afford to purchase homes right now, and there aren’t as many homeowners eager to refinance their existing loans now that rates have jumped. Mortgage applications plunged 53.6% from a year ago in the week ending June 3, according to the MBA. So lenders are making loans to applicants with lower credit scores and more debt.
“They’re stressed for income,” says David Stephens, CEO of Mountain Lake Consulting. He was a former CEO of the MBA and the Federal Housing Administration commissioner during the Obama administration. “They just need more loans in the hopper to stay alive.”
In April, borrowers had a median FICO score of 735, according to data provided by the Urban Institute. While that’s considered a “good” score, it’s down from a “very good” score of 761 just a year earlier, Meanwhile, debt-to-income ratios increased to 39% in April versus 35% in April 2021. (The ratio refers to how much debt someone has, including their mortgage, versus their earnings before taxes. The higher the score, the more debt a borrower will have.)
Most lenders want borrowers to have at least a 580 FICO score and a debt-to-income ratio no higher than 43%. And unlike in the mid-2000s, they require extensive documentation to verify that borrowers earn as much money as they claim to avoid borrowers being unable to make their loan payments.
“There were some protections that were put in place in the wake of the last foreclosure crisis, but they’re not a silver bullet,” says Mancini. “Everyone has thought that subprime lending is not going to come back, [but] there’s no reason to think that it can’t or it won’t. These might be the market conditions that lead to that.”
Are ARMs and interest-only loans risky?
ARMs and interest-only loans could get borrowers in trouble because they become more expensive over time. In the late-2000s, this became a big problem as many homeowners couldn’t afford those higher balloon payments and lost their properties to foreclosure. The loans offered today are much safer for borrowers and lenders. But there is still risk involved in taking one.
ARMs generally offer a significantly lower mortgage rate for the first years of the loan—generally a set five, seven, or 10 years. When that period ends, the rate adjusts to market rates at that point in time. If the rate is lower, then borrowers can save some money each month. However, if it’s higher, borrowers are on the hook for larger monthly payments for the remainder of the loan. Typically, there is a cap on just how much higher the rate can go to try to prevent the huge swings seen before the housing bubble of the 2000s.
It’s not hard to see the appeal of these loans. The rate for a five-year ARM averaged 4.12% for the initial five years of the loan in the week ending June 9, according to Freddie Mac. Meanwhile, it was 5.23% for a 30-year fixed-rate loan that keeps the same mortgage rate for all 30 years. (Rates have since spiked in anticipation of the U.S. Federal Reserve meeting on Wednesday. Freddie Mac doesn’t release its weekly data until Thursday, but Mortgage News Daily reported rates were nearing 6.30% on Tuesday for 30-year loans compared with 5.5% for five-year ARMs.)
“You are seeing a notable shift toward adjustable-rate mortgages,” says Laurie Goodman, a fellow who specializes in housing at the Urban Institute, a Washington, DC–based think tank. “The ARM rate is substantially lower than the fixed rate.”
Breaking that down, it’s a difference of about $240 a month on a $446,950 home, which is the national median list price. (This assumes the borrower put down 20% and doesn’t factor in property taxes, insurance, and any homeowners association fees.) However, the fear is that, after the rate adjusts, buyers might be saddled with a payment they can’t afford.
Another worrisome loan is the interest-only mortgage, which has recently been making a comeback, says Shmuel Shayowitz. He’s the president and chief lending officer of Approved Funding, a mortgage lender based in River Edge, NJ, and he’s seeing more borrowers look into these mortgages—although few, for now, are taking them out.
Interest-only loans are also generally cheaper than 30-year fixed-rate loans. Borrowers pay only the interest on the loan for a set period, generally five to 10 years. Once that ends, they must pay the interest and the principal that they owe. And suddenly those loans become significantly more expensive as buyers now need to pay back what they borrowed in a shorter time frame.
The interest rates are also generally higher on these loans, says Shayowitz. “Ultimately, you’re paying money because you’re automatically starting with a higher rate.”
This kind of lending might be a good choice for investors looking to make their numbers work, but regular borrowers should proceed with caution. If they don’t offer larger down payments, and home prices fall, they could find themselves underwater on their loans. They might also have trouble affording their mortgage payments when they’re responsible for paying back the principal and the interest.
“If someone is utilizing these loan alternatives, an interest-only or ARM, because they otherwise wouldn’t qualify for a loan with a higher payment, then perhaps they should think twice about it,” he says.
But for some homebuyers, they might be a cost-effective option. Most people stay in mortgages for only five to seven years before refinancing the loan or selling the house and buying another one, says mortgage broker Rocke Andrews, of Lending Arizona in Tucson. And if someone planned to stay in the home only five to seven years, ARMs could help them to save quite a bit of cash.
“Very few people keep a mortgage for 30 years,” says Andrews. “First-time buyers move up … and people move or get transferred.”
More buyers are stretching their budgets to afford homes
Certified financial planner Roger Ma recommends buyers don’t spend more than 28% of their income (before taxes) on housing, which includes property taxes, insurance, homeowners association fees, etc. They should also save about 1% of the purchase price of their home each year for maintenance and repairs.
He also advises clients to examine their expenses and what they’re spending to figure out what they can realistically afford before they enter into an emotional bidding war—an often-frenzied process where they might be tempted to overextend their budgets.
“Do that pre-work so when things get crazy you have the guideposts in place,” says Ma. “Ask, ‘Can I really afford this on an ongoing basis?’”
That’s tough to do in today’s market when median list prices were up 17.7% year over year in May to just about $447,000 nationally.
“At the end of the day, despite whatever the lender may tell them, homebuyers really need to think: ‘Can I really afford this payment?’” says Stephens. “We’re creating a whole bunch of people who are house poor. … It’s only getting worse and, frankly, it’s being overlooked.”
Those who don’t want to get in over their heads with their housing payments might not have any other choice as rents continue surging. (Rents jumped 15.5% in May compared with a year earlier, according to Realtor.com data.) The thinking is that, with homeownership, they’ll at least be building equity and lock some of their housing costs. While property taxes, insurance costs, and utility bills might rise, they’ve locked in the largest part of their housing bills.
“The amount that you’re spending on rent is not that far off from the amount it would cost you to purchase a home,” says Barry Habib, CEO of MBS Highway, which provides housing and mortgage data and creates forecasts. Buyers “are stretching, and they have to stretch sometimes. As the mortgage payments stay fixed, their incomes go up and that payment becomes more comfortable.”
Most of mortgage broker Andrews’ clients are having such a difficult time having an offer on a home accepted, “they’re not going to let the cost of the mortgage stop them,” he says.
“Desperation will cause some people to say, ‘Maybe I’ll get a second job or we’ll figure it out,’” says Stephens. “Because what’s the choice?”
Another foreclosure crisis isn’t likely for this reason
Many Americans are worried another recession is headed for the U.S. economy. But those expecting a recession to bludgeon home prices—making homeownership more attainable for those still financially secure, like during the Great Recession—might not want to hold their breath.
There are still far more buyers than there are homes for sale (or even for rent). That’s likely to keep home prices high. It would take an influx of cheap housing to hit the market, such as another foreclosure crisis, for prices to fall steeply. And that doesn’t seem likely.
Homeowners struggling to make their mortgage payments could sell their properties, rather than lose their homes to foreclosures. Many would even be able to walk away with a profit.
In addition, home sellers can afford to be choosier—so they are.
Cash offers have proliferated throughout the housing market. Buyers who don’t have all cash are scrambling to come up with the larger down payments to make their offers stand out. Sellers have so many eager buyers for their homes that they’re less likely to accept offers from buyers on the margins, such as those with smaller down payments. This means many of today’s homebuyers go into their homes with ample equity.
“Lending has been pristine since the financial crisis. Mortgage lenders have been very cautious,” says Mark Zandi, chief economist at Moody’s Analytics. “So we’re very unlikely to get a significant increase in defaults, foreclosures, and foreclosure-distressed sales.”