A Guide to Subprime or ‘How to ruin your country’s economy too’

Economists in any country in the world – except the United States – should study the “interest only” loan. It is imperative so your economy doesn’t get hurt in the future. Just consider the United States as a training ground. We all saw the ripple effect around the world. If your country’s stock market lost $80 million in one day, or if your country’s central bank pumped billions of dollars into your economy, your economists should study the interest-only scam so you can prevent it.

More specifically one should look at the effect of these loans when they are extended to the general population, including those who cannot afford them. Originally designed for well-qualified borrowers expecting a large dividend or perhaps a salary bonus, interest-only loans made sense. They were designed so one would not be required to touch their assets while repayment was virtually guaranteed.

Consider what happens when traditional banks and loan companies adopt this type of loan. A borrower calls each bank, asking about the amount of a desired loan, interest rate, and payment. Look at it a different way. A person unknown to you calls you one day, says you don’t owe his company any money, but wants you to pay him $275 a month for five years, and at the end of five years you still won’t owe him any money. Stupid, is it not? Yes it is, but in the United States it is the basis of subprime lending. Here is how it works.

Using your home as collateral you get a second mortgage. The amortization period is much longer than the payback period. That means the payment is so low you never pay anything on the principle, and all you ever pay is interest. At the end of the repayment period you owe as much as you borrowed years before. (See footnote 3) If the finance company tells you the truth before you sign the contract it is your decision. If they lie to you, or leave out pertinent facts through acts of omission, they are predatory lenders. HSBC’s Household International is a prime example of predatory lending. (1)(2)(3)

Take the example one step further. In an effort to profit from low interest rates and lax lending standards, mortgage lenders learned from HSBC and Household International. They decided to call the product an interest-only loan. Just pay the interest for a year or two and everything else will be packed on to the back end of the loan. A product for the wealthy is now marketed to the masses. If you use this kind of financing to buy a house, fix it up, and flip the property before a payment is due, the product might work for you. If you use this kind of financing to buy or refinance your primary home you might have a problem unless your huge year-end bonus will pay off the loan. If everyone on earth knows you will not get a year-end bonus somebody will sell you this mortgage product anyway.

Footnotes(1) Practices with regard to home equity lines of credit: Plaintiffs allege that Defendant extended what was in substance closed-end credit disguised as open-end credit with the intent to avoid making meaningful disclosures concerning the payment terms, such as the existence of large balloon payments. Plaintiffs further allege that Defendant extended what was in substance closed-end credit with APRs in excess of 10% over the US treasury rate for comparable maturities, which Defendant disguised as open-end credit to evade the requirements of the Home Ownership and Equity Protection Act, 15 U.S.C. § 1639.

(2) Loan billing practices relating to simple interest calculations: Plaintiffs allege that Defendant’s practices by which payments were credited to accounts on the basis of the number of days between payments frequently resulted in situations in which scheduled payments were insufficient to pay accrued interest, creating a shortfall in interest (“interest short”), which resulted in excess finance charge costs for borrowers. Such shortfalls could occur even when payments were not late. Defendant further made representations concerning the opportunity to “skip a payment” without informing consumers that doing so would result in “interest short” situations. Defendant failed to provide borrowers with material information necessary to avoid such extra charges.

(3) Balloon payments: Plaintiffs allege that Defendant extended credit to borrowers on terms that would eventually require balloon payments, without disclosing to borrowers the existence or amount of the balloon payments.