2/28 and 3/27 loans too costly to work

Golden dollar sign

The dangerous and expensive 2/28 and 3/27 loans that forced so many subprime borrowers into default or foreclosure are gone.

Until very recently, these adjustable-rate loans were the most common type of mortgages offered to borrowers with bad credit, accounting for three out of every five subprime loans.

The idea was to provide borrowers with a two- or three-year introductory interest rate that was lower than any fixed-rate subprime loan they could qualify for.

By making all of their payments, borrowers were told they could raise their credit scores and refinance into a far more affordable fixed-rate mortgage before their 2/28 or 3/27 ARM reset to a higher interest rate after two or three years.

Mortgage brokers told borrowers they shouldn't worry about the reset because they'd never have to deal with it -- or the dramatically higher payments.

But here's what really happened.

Many borrowers were unable to refinance into a lower-rate mortgage because they couldn't boost their credit score high enough to get a conventional loan.

Or they didn't have enough equity in their homes to refinance their loan. That's been a particularly serious problem for buyers who put nothing down and financed 100% of the purchase price.

They were trapped and their mortgage payments exploded.

Most 2/28 mortgage rates are tied to an index known as the 6-month LIBOR or London Interbank Offered Rate -- the rate European banks charge each other to borrow money.

Most ARMs given to borrowers with good credit charged LIBOR plus 2.75%.

2/28 loans typically reset to LIBOR plus 6.25%. Since the index is around 5% right now, that meant loans that had been charging 5% or 6% interest quickly began climbing toward 12% or 13%.

ARMs given to borrowers with good credit usually reset no more than once a year, and could increase no more than 2 percentage points a year.

2/28 loans reset every six months and could increase 3 percentage points the first time, and 1 percentage point each time after that.

Homeowners who began paying 6% saw their monthly payments increase from $600 a month for every $100,000 they had borrowed (principal and interest only) to $1,100 a month after the first two resets.

No wonder First American Real Estate Solutions, a division of First American Corp., expects one in eight borrowers who took out 2/28 mortgages during the boom years of 2004 and 2005 will default on their payments.

Because of that, lenders have dropped these, and most other types of costly programs aimed at borrowers with bad credit.

Given how awful most of those subprime loans were, that's actually a good thing.

About the only way subprime borrowers can get a mortgage right now is by qualifying for a federally-backed loan program.

Before setting out to buy a home, however, work on raising your credit score. It's not a quick process and it's not easy, but it will pay dividends for years.

The higher your credit score, the lower the interest rate you will pay on your mortgage, auto loan and insurance premiums. Our "6 smart moves to improve your credit score" can help you do that.

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