Though not quite as contemptible as an obscene four-letter word, the term “subprime loan” comes close.  Those two words acquired a stigma over the past year as the real estate market essentially collapsed.  It’s the rare financial analyst that fails to remind us how subprime lending resulted in nationwide misery.  Unfortunately, after uttering that accusation, many counselors are remarkably imprecise as to exactly what constitutes a subprime loan.  Does a home bought with no down payment and a loan equal to 100% of the purchase price qualify?  You’d certainly think so from the articles I read.  And what about loans where little or no principal payments are made during the early years?  The suggestion normally conjures up predictions of impending disaster. 

At the risk of sounding indifferent to living dangerously, I’m not averse to either of these two borrowing techniques.  Actually, the harshly criticized zero-down purchase doesn’t necessarily mean high risk.  For over half a century the widely used GI loan, created by the Servicemen’s Readjustment Act of 1944, provided military veterans with home loans on a nothing down basis.  Countless ex-servicemen profited handsomely from this program.

As for failure to make principal payments during the early years of a loan, this became, in essence, the normal method of home financing following the Great Depression of the 1930s.  Consider the typical FHA loan, by which millions of Americans acquired their residences.  The standard 30-year fully amortized fixed-rate loan provides that at the completion of the first five years of scheduled payments, about 95% of the original balance remains unpaid.  Even after ten years, 85% is still owed.  This is because most of the payments in the early years go toward interest.  Technically this may not equate to no payments of principal, but it comes pretty close.

This, then, conjures up the question: Exactly what differentiates current subprime lending abuses from earlier-day practices perceived as creative.  As an example of this latter practice, consider a device I used extensively in the high interest rate period of the 1970s and 1980s, known as an all-inclusive mortgage (also called a “wrap-around”).  In this circumstance, a property is sold subject to a seller’s carryback mortgage loan, junior to and inclusive within an existing first mortgage that remains on title.  Providing the underlying loan carries no due-on-sale provision, which many at the time did not, it’s a permissible technique.  This contrivance, though unconventional, provides benefits to both buyer and seller when properly structured.

This gets us down to the crux of matter, which is abuse in home financing.  It’s a subject that easily fills volumes.  However, at its heart is a basic discord: home acquisition beyond a purchaser’s ability.  It is this that made subprime lending an insidious perversion.  The entire loan industry joined together, incorporating various devices in its quest to finance houses.  Certain practices now under scrutiny by legislators and regulatory agencies included minimal initial interest rates scheduled to adjust upward at a later date, buyer qualification based upon unrealistic low initial monthly payments, and loan approval of buyers whose credit history indicated unreliability.  Although these factors all contributed to the final calamity, they were not the cause, but merely the effect.

Fundamental to it all is creation of loans by entities whose funds are not at risk.  When loan authorization is granted to processors who profit on creation, but who are unaffected by later payment failure, unsafe lending is guaranteed.  It is not by accident that loan approval rested largely with mortgage lending firms that merely complied with established institutional criteria, often nonsensical.  All participants profited handsomely by the fees generated through loan creation, despite easily predictable default at some later date.  In reality, sound practices are attainable with no special prohibitions or regulatory oversight.  Though I’m actively engaged in mortgage lending, I’ve yet to experience a single foreclosure so far this century.  The reason is fundamental.  I don’t loan other people’s money—I risk my own.  My personal self-interest insures that loans go only to borrowers who I feel confident will honor their obligations or, that if unexpected misfortune strikes, the loans are amply backed by the securing properties.  That’s what the secured loan business is all about.  What must exist are circumstances by which the maker of the loan only profits from good loans, not bad ones.  Enacting a mass of rules to thwart bad intentions is not the answer, for no law will ever obstruct the human capacity for connivance.

I’ll briefly summarize with my admonition to the typical homebuyer.  I advocate that you not commit to obligations that strain your limits.  It’s more sensible to restrict yourself to less than you can handle.  Simply put: Choose a cheaper home than you can afford.  And while we’re on the subject, you might apply that same formula to other aspects of your life.  You’re far better off if your vehicle, your home furnishings, and your vacations are well within your means.  More specifically, these three products should be obtained with no borrowing of any sort.  Maintaining a standard of living that requires you to stretch regularly to meet payments is not really much fun.  Cash on the barrelhead may seem old-fashioned, but it makes for a more enjoyable way to live.