Alt-A Mortgages: How They Work
A house is probably the single largest investment you will ever make, and if you're like most, you'll need a mortgage to finance it. Mortgages are loans that are secured by specified real estate – namely, the house that the loan is being used to purchase. Depending on factors like your credit score, employment history and the loan-to-value (LTV) ratio, you may be offered a prime mortgage, subprime mortgage or something in between: an Alt-A mortgage. Here, we take a quick look at the Alt-A mortgage, and why Wall Street wants to bring them back.Alt-A Basics
Most mortgages are either prime or subprime. Prime mortgages are offered to borrowers who have higher credit scores (and, therefore, lower risk), and come with lower interest rates. Subprime mortgages go to borrowers with lower credit scores and – to make up for the added risk – lenders charge higher interest rates on them. Alt-A mortgages are loans that fall somewhere in between the prime and subprime category in terms of risk and interest rates. (For more, see How Interest Rates Work on a Mortgage.)Characteristics
One of the defining characteristics of Alt-As is that they are typically low-documentation or no-documentation loans, meaning the borrower doesn't have to fully document (or prove) his or her income, assets and expenses. Instead of documentation and verification, these loans are processed based on the borrower's stated income, assets and expenses. It would be easy to make something up on the application. (For more, see Top 6 Mortgage Mistakes.)
Another characteristic of Alt-As is that they often have a relatively low down payment, and a corresponding higher LTV ratio. With a prime mortgage, the LTV is typically 80% or less. With an Alt-A, the LTV could be 100%; in this case, the borrower doesn't have to put any money down.
The debt-to-income ratio (DTI) on Alt-As also tends to be slightly more flexible than on other mortgages. These concessions essentially allow borrowers to buy more house than they might reasonably be able to afford. As such, Alt-A borrowers are at a greater risk of default than prime borrowers – thus the higher price.
If you are offered a mortgage that seems larger than you thought you could get – and are asked for less background information and charged more interest than you'd expected – be sure you're not getting an Alt-A mortgage by accident. Researching options with more than one lender can help you determine how much is wise to borrow and what you should expect to pay for it. If you do consider one of these loans, be sure you know the tradeoffs before you agree to it.There and Back Again
Alt-As were incredibly popular in the years leading up to the subprime mortgage crisis that began in 2007. They became known as liar loans because borrowers and lenders alike could exaggerate income and/or assets to qualify the borrower for a larger mortgage. As people became overextended, many of these mortgages fell into default. Though Alt-As weren't the only misstep leading up to the financial crisis, they certainly contributed to it. Consequently, they fell under intense scrutiny. (For more, see Who Is to Blame for the Subprime Crisis?)
After the dust settled, tighter lending standards were enacted, and Alt-As became a thing of the past. Now, however, investment firms, looking for a way to earn a good yield in a world of low interest rates, are lobbying lenders to make more Alt-A loans. This has been quietly in the works for a while but received attention in an article that appeared in the Wall Street Journal on February 1, 2016. Big money managers including Neuberger Berman, Pacific Investment Management Co. and an affiliate of Blackstone Group LP are lobbying lenders to make more of these ‘liar' loans – or even buying loan-origination companies to control more of the supply themselves, the Journal reported.A Good Option for Some
Despite their susceptibility to fraud – from both borrowers and lenders – Alt-As can be a good option (indeed, sometimes the only option) for borrowers who are unable to document assets and/or a consistent income. Small business owners, for example, may have trouble documenting the of funds for a down payment, or may be hurt by their net income figures – which can be lowered by business deductions. Self-employed borrowers try to write off as many expenses as they can, but that tactic may hurt them when securing a loan, Patrick Ruffner, vice president of mortgage lending at Chicago-based mortgage company Guaranteed Rate, told U.S. News & World Report.
For borrowers in this situation, who otherwise may have trouble securing financing, Alt-As can provide an alternative.The Bottom Line
The proliferation of abuse with Alt-A mortgages was a contributing factor to the subprime mortgage crisis. Bringing them back now to benefit investment firms seems like a bad idea. Einstein famously said that insanity is doing the same thing over and over again and expecting different results. Is Wall Street really expecting things to turn out differently this time around?