3 Risks Involved with Alt-A Mortgages

Alt-A Mortgages are mortgage loans that are riskier than prime mortgages but not quite as risky as sub-prime mortgages. During the most recent real estate boom, they attracted many borrowers because they had loose eligibility requirements and offered plenty of funds to the borrowers, opening the path to home ownership to those who could not afford it. Even during the boom years, Alt-A mortgages were risky to borrowers and lenders alike, but the extent of this risk did not become widely apparent until the real estate bubble burst in the late 2000s. While Alt-A mortgages are still available, they are not nearly as popular as they used to be.

1) Loose Eligibility Requirements

When a mortgage lender issues a loan, it usually wants some assurance that the borrower will be able to pay it back. It requires the borrower to complete an application that allows it to analyze his or her financial history in order to decide whether the borrower can afford to repay the mortgage loan and, if so, how big the loan will have to be in order to remain repayable.

In Alt-A mortgages, those requirements are all but abandoned. With some Alt-A mortgage loans, the borrower isn't required to show proof of income. All he or she has to do is give the lender a figure, and the lender will treat it as fact. The credit score requirements are also lower than they are for most other mortgages, allowing borrowers who either had debt in the past or are still repaying their debt to apply.

These loose eligibility requirements lull the borrowers into a false sense of security, allowing them to take out loans that they may not be able to repay. This means that the borrowers who took out Alt-A mortgages are far more likely to default on their loans than borrowers who took out loans with more stringent requirements. This also means that the lenders are far more likely to lose money. The borrowers can avoid defaulting on their mortgage loans if their financial situation significantly improves. However, this is an unrealistic scenario for most borrowers.

2) High Interest Rates

When a borrower takes out the loan, he or she must make monthly payments. Those monthly payments are split into two main parts--principal and interest. Principal is the portion of the money the borrower got from the mortgage lender. Interest is essentially a fee the lender charges for managing the borrower's loan. Interest allows each lender to earn profit on its loans, so it's only natural that each lender will want to earn as much profit as possible. However, it cannot raise interest too high, or no borrower will want one of its loans.

Alt-A mortgages are designed to work around this. They offer low introductory rates. Introductory rates are set in place for a limited period. Once that period passes, the interest rates rise exponentially. Just because the borrowers have been able to afford introductory rates doesn't mean the borrowers will be able to afford new, higher interest rates. This makes the possibility that the borrowers will default even more likely than before.

3) Lack of Mortgage Insurance

Mortgage insurance is the insurance policy that compensates lenders if a borrower defaults on his or her mortgage. During the boom years, mortgage insurance often covered Alt-A mortgages. Once the housing bubble burst, mortgage insurance providers backed out. deeming them too unprofitable. This means that if the borrower defaults, the lender will have to cover the losses all by itself. It can do that by foreclosing on the property and selling the house, but with the real estate values still (in 2010) at historic lows, it most likely won't make up all of the losses.

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