Life Cycle of a Loan
Traditionally, a loan's life cycle involves two parties: A lender and a borrower. But in order to reduce risk, lenders today often sell loans on a secondary market to national companies which are funded by mortgage-backed securities. Loan-to-value ratios, more than ever, are affected by national and international financial dynamics, which affect interest rates as well as market risk.
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Adjustable Rate Mortgages
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Loans can either have a fixed rate or an adjustable rate--either the monthly payment stays the same over time, or it is adjustable based on market conditions. Depending on their credit scores, some borrowers only have the option of an adjustable rate, particularly when they can only take on a loan if they can start with lower monthly payments.
Housing Crisis
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During the housing crisis of 2007 and 2008, large numbers of borrowers were unable to maintain monthly payments of adjustable rate mortgages once the payments increased significantly after a few years into the loans. Banks assumed that lower income individuals could afford an adjustable rate mortgage. They expected the individuals' incomes to increase and/or the value of properties to increase which would allow owners to more affordably refinance mortgages before adjustable rates hit.
"Loan incentives such as 'interest-only' mortgages, low initial 'teaser' rates, repayment holidays and laxer lending criteria are frequently cited as having encouraged borrowers to take on more debt than they can handle," says M. Ricardo Cuaha, who wrote an academic paper with international colleagues on the subject in 2009.
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Impact to Economy
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Unfortunately, multiple foreclosures not only affected homeowners, but they impacted investors. The mortgages packaged into mortgage-backed securities lost value almost overnight, and investors took the loss.
"Any wave of households entering into negative equity, resulting bankruptcies and forced sales would all feed back into the stability of the financial system, consumer demand and, in general, economic growth itself," Cuaha says.
Traditional vs. Modern Loans
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Traditionally, the bulk of the interest paid during the life of a loan is usually paid in the first fourth or fifth of the loan payments. This gives individuals an incentive to make larger payments in the first few years in order to hit the principal of the loan and thus reduce the overall cost of borrowing the money. This set-up also allows lenders to use the interest to fund new loans and to, in essence reduce risk.
Although fixed rate loans still have the same structure in terms of how interest pays out, individuals with adjustable rate mortgages often have no way of increasing their monthly payments early on in the loan, which means the loans are more expensive and take longer to pay off.
Life Cycle of a Loan
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Unlike traditional loans, the life cycle of a loan impacts not just a local economy, but national and international markets. This is because of the role that mortgage-backed securities play in the banking industry today. The housing crisis has taught a very important lesson. Bankers must properly establish borrowers as being adequately able to pay the money back, to protect both the borrowers' credit as well as the economy.
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References
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