During the Great Recession, the U.S. economy took a major hit because of mortgage foreclosures. Borrowers all over the nation had trouble paying their mortgages. At the time, eight out of 10 borrowers were trying to refinance their mortgages. Even high-end homeowners were having trouble with foreclosures. Why were so many citizens having trouble with their mortgages? Here are six reasons.

Key Takeaways

  • Adjustable-rate mortgages offer a low initial rate that results in lower payments; however, the interest rate resets after a period of time.
  • Putting no down payment on a mortgage can make it more likely that the borrower’s house ends up “underwater.”
  • Reverse mortgages have high upfront costs, are riddled with numerous fees, and result in losing equity in your home.
  • Longer time frames for mortgages result in less equity in the home and more interest paid—making it difficult for the owner to move.
  • Exotic mortgage products can result in buyers building negative equity.

1. Adjustable-Rate Mortgages

Adjustable-rate mortgages (ARMs) can seem like a homeowner’s dream. These mortgages start borrowers off with a low interest rate for the first two to five years. They allow you to buy a larger house than you can normally qualify for and have lower, more-affordable payments. After two to five years, though, the interest rate resets to the market rate, which is generally higher. This isn’t an issue if borrowers can just take the equity out of their homes and refinance to a lower rate once it resets. Or, alternatively, if the buyer didn't stay in the home for long, it may already have been sold by the time the rate would have changed. (This type of mortgage can be a good choice for someone whose job requires frequent relocation.)

However, it doesn’t always work out that way. When housing prices drop, borrowers tend to find that they are unable to refinance their existing loans. This leaves many borrowers facing high mortgage payments that are two to three times their original payments.

Shopping around with different lenders, offering complete and truthful information on your mortgage application, and addressing credit problems as they occur are the best steps you can take to get a fair and practical mortgage.

2. No Down Payment

One trigger of the subprime crisis was that many companies had offered borrowers no-down-payment loans. Here's why that became a problem.

The purpose of a down payment is twofold. First, it increases the amount of equity that you have in your home while reducing the amount of money that you owe on it. Second, a down payment makes sure that you have some skin in the game

Borrowers who make large down payments are much more likely to try everything possible to make their mortgage payments, as they do not want to lose their investment. On the other hand, many borrowers who put little to nothing down on their homes and find themselves upside down on their mortgage end up just walking away because they owe more money than the home is worth. The more a borrower owes, the more likely they are to walk away, putting the mortgage in foreclosure.

3. Liar Loans

The term “liar loans” may sound disreputable, but such loans were incredibly popular during the real estate boom before the subprime meltdown that began in 2007. Mortgage lenders were quick to hand them out, and borrowers were quick to accept them. A liar loan requires little to no documentation and no verification. The loan is based on the borrower’s stated income, stated assets, and stated expenses.

They are so named because borrowers have a tendency to lie, inflating their income so that they can buy a larger house. Some individuals who received a liar loan did not even have a job. The trouble starts once the buyer gets in the home.

As the mortgage payments have to be paid with actual income—not stated income—the borrower is unable to consistently make mortgage payments. They fall behind on the payments and end up facing bankruptcy and foreclosure.

4. Reverse Mortgages

If you watch television, you have probably seen a reverse mortgage advertised as the solution to all of your income problems. A reverse mortgage is a loan available to homeowners age 62 and up that uses the equity out of their home to provide an income stream. The available equity is paid out to borrowers in a steady stream of payments or in a lump sum such as an annuity.

There are many drawbacks to getting a reverse mortgage. There are high upfront costs. Origination fees, mortgage insurance, title insurance, appraisal fees, attorney fees, and miscellaneous fees can quickly eat up equity. The borrower loses full ownership of the home.

Once the mortgage is in effect, all the borrower's equity is gone from their home; the bank now owns it. Their beneficiaries are only entitled to whatever equity may be left after all of the cash from the borrower's estate has been used to pay off the mortgage, fees, and interest. Their children could have to try to work out an agreement with the bank and make mortgage payments if they want to keep the family home.

5. Longer Amortization

You may have thought that 30 years was the longest time frame that you could get on a mortgage, but some mortgage companies are now offering loans that run as long as 40 years. What’s more, 35- and 40-year mortgages are slowly rising in popularity. Why? They allow individuals to buy a larger house for much lower payments. 

A 40-year mortgage may make sense for a 20-year-old who plans to stay in the home for the next 20 years, but it doesn’t make sense for other people. The interest rate on a 40-year mortgage will be slightly higher than a 30-year. This amounts to a whole lot more interest over a 40-year time period, because banks aren’t going to give borrowers 10 extra years to pay off their mortgage without making it up on the back end.

Borrowers will also have less equity in their homes. The bulk of payments for the first 10 to 20 years will primarily pay down interest, making it nearly impossible for the borrower to move. This also makes retirement harder if you’re making payments into your 70s.

6. Exotic Mortgage Products

Other types of mortgages developed before the Great Recession also led to foreclosure. Lenders came up with all sorts of exotic products that made the dream of homeownership a reality. Some homeowners simply did not understand what they were getting themselves into. Two examples:

  • Interest-only loans can lower payments 20% to 30%. These loans let borrowers live in a home for a few years and only make interest payments.
  • Name-your-payment loans allow borrowers to decide exactly how much they want to pay on their mortgage each month.

The catch for both products is that a big balloon principal payment comes due after a certain period. All of these products are known as negative amortization products. Instead of building up equity, borrowers are building negative equity. They are increasing the amount they owe every month until their debt comes crashing down on them like a pile of bricks. Exotic mortgage products have led to many borrowers being underwater on their loans.

The Bottom Line

The road to homeownership is riddled with many traps. Avoiding them is one of the keys to staying out of financial trouble. Perhaps a good adage to keep in mind is that if something seems too good to be true, it probably is.