A toxic mortgage is a type of home loan that has lost a significant amount of value for a lender when housing prices fall. When a homeowner is unlikely to ever pay that mortgage loan back, the lender would consider this a toxic mortgage and initiate foreclosure to try to recoup some of the outstanding mortgage debt. If the housing market crashes and it is difficult to sell the real estate or the debt, a bank or credit union with multiple toxic mortgages can be in real trouble.
When a Mortgage Loan Becomes Toxic
For most people in the United States, making a home purchase means getting a residential mortgage loan from a lender. In the typical process, a potential homebuyer gets preapproval for a specific purchase price, then shops around to banks and credit unions to find the best annual percentage rate (APR) and loan terms.
When the lender issues a conventional mortgage, after a down payment and closing costs, the homeowner agrees to pay it back for the term of the loan at a particular interest rate.
Over the life of the mortgage loan, homeowners pay back the value of the real estate, plus property taxes and interest. If the borrower's down payment is below a certain minimum – usually 20 percent – the Consumer Financial Protection Bureau says the lender will require private mortgage insurance (PMI) as an additional line item on the monthly mortgage payment.
Having outstanding loans that borrowers gradually pay off is usually good for a bank. When mortgage loans become toxic, and lenders can't move foreclosures, these mortgages can become a financial burden for a financial institution and the economy.
Mortgage Loans in Default
Sometimes, mortgagors encounter a life event that causes them to become unable to make payments on their loans. Loss of a job, death of a spouse or serious medical issues can make it impossible to keep up with the monthly mortgage payment.
If the borrower is unable to refinance, secure a reverse mortgage, receive a deferment or forbearance, take a home equity loan or find some other solution , the loan will go into default, cautions the Navy Federal Credit Union.
The mortgage can be considered "toxic" as soon as the borrower stops making payments. When this happens, the mortgage lender has the legal right to put the home in foreclosure and sell the real estate at public auction to get some money in a lump sum to help cover the loss of the unpaid mortgage debt.
Loans Set Up to Fail
After the housing crash of 2008, regulation of lending practices has been reformed, and oversight is strong. However, certain types of loans, such as a negative amortization loan, are considered toxic because the borrower is unlikely ever to be able to pay off the mortgage loan's principal.
Amortization refers to paying down a loan over time so that the total amount you owe is reduced with each monthly payment and will be $0 by the end of the term of the loan. Nearly all mortgages are amortized, regardless of their interest rate structure.
An adjustable-rate mortgage has an interest rate that changes based on the housing market, while a fixed-rate mortgage remains the same throughout the mortgage. Both types of mortgages are set up for an owner to pay the loan balance, including interest, with regular payments.
The CFPB mentions that negative amortization loans offer low payments but add unpaid interest to the mortgage debt. As a result, homeowners with this type of loan have difficulty building home equity and can have a big problem when needing to sell their home, apply for a home equity line of credit or take out a second mortgage.
The inherently increased risk of foreclosure makes this type of loan a toxic mortgage.
An Unhealthy Housing Market
In the 2008 financial crisis, subprime lenders who gave mortgage loans to high-risk, first-time homebuyers and homebuyers with poor credit histories and low credit scores were primarily to blame.
Wharton real estate professors Susan Wachter and Benjamin Keys point out that investors also had a role by refinancing multiple investment properties to take advantage of subprime interest rates.
In addition, many mortgage bonds sold during the housing boom were based on mortgages that didn't meet Fannie Mae and Freddie Mac's criteria. In other words, unlike low-interest residential mortgages offered by the Federal Housing Authority (FHA) or Department of Veterans Affairs (VA), these loans were not government-backed or guaranteed.
When home prices peaked and borrowers couldn't make their monthly mortgage payments, the boom ended and the bubble burst. The value of these bonds diminished and the bonds became toxic assets related to mortgage debt.
Toxic Mortgages and Economic Downturn
Toxic mortgages can be both the cause and the effect of general economic downturns. If unemployment rises steeply, fewer people can make their mortgage payments, and foreclosures will increase.
When foreclosures increase, real property values decrease, which stalls the construction industry, which in turn stalls growth in every related industry. Unable to sell these homes or pass these toxic mortgages to other banks for what they paid in loan money, financial institutions might have to close their doors.
This article was written by PocketSense staff. If you have any questions, please reach out to us on our contact us page.