For Home Loans, is Road Less Taken Worth the Bumpy Ride?

by Houston Agent

Some first-time homebuyers are taking alternate paths to financing their purchases.

Mortgage lending has returned to its pre-bubble requirements, and some homebuyers are unable to meet private banks’ standards for income, credit scores and other financial factors.

We’ve covered on numerous occasions the ascent of Federal Housing Administration loans in the face of tougher financing, but Annamaria Andriotis of The Wall Street Journal has spotlighted several other, less common financing options that some prospective homebuyers are pursuing.

For instance, one-third of first-time homebuyers are now financing their down payments with cash gifts from family or friends, an increase of 6 percent from the historical average, according to the National Association of Realtors. In some cases, homebuyers are even taking out loans from their parents.

Michael Garry, a financial planner quoted in Andriotis’ piece, said a parental loan can be a win-win for both parties. The son or daughter receiving the loan pays a lower interest rate than a private bank loan (or without the fees and insurance of a public loan), and the parent giving the loan receives interest at a greater rate than any CD or money-market fund, so while the child pays less, the parent earns more.

According to Jonathan Bergman, of Palisades Hudson Financial Group, interest rates for such loans follow specific federal law, and range from minimums of 0.2 percent to 2.8 percent.

Andriotis also looks at peer-to-peer lending sites, such as Prosper and Lending Club, which screen applicants and then offer them loans that are pooled together from investors. Another site, Miami-based Weemba, finances loans from 30 different companies, including banks and credit unions, for some 3,000 registered users. Like the aforementioned sites, the 30 companies screen the applicants and directly contact users they are interested in assisting.

As convenient as the peer-to-peer sites are, though, they do come with some disadvantages, namely in the form of higher interest rates. Lending Club loans charge anywhere from 7 to 28 percent, while rates at Prosper range from 7 all the way to 35 percent.

The companies told Andriotis that their high rates are because of the unsecured nature of the loan, but average rates at both federal and private institutions are at their lowest levels in decades. For instance, the latest Freddie Mac averages put the 30-year FRM at 3.99 percent and the 15-year FRM at just 3.27 percent.

The private, unsecured loan market is definitely growing – Weemba featured just 12 investor companies in September – but as Felix Salmon has written for Reuters, the reality of financial risks may have undermined the intention of peer-to-peer lending.

“Peer-to-peer lending was meant to create a personal connection between borrower and lender, and therefore make borrowers more likely to repay their debts than people faced with large obligations to hated, faceless banks,” Salmon wrote, basing his post on a 2010 article by Mark Gimein that Prosper responded to.

“It seems that adverse selection effects overwhelmed the site’s attempts to be warm and fuzzy,” Salmon wrote.

In other words, though lending at peer-to-peer sites such as Prosper and Lending Club set out to be more open, they have since re-tooled their business models and now follow the same underwriting standards of other, securitized loan operators with loans of various ratings. Prosper, for instance, relaunched their operations in 2009 with an entirely new lending apparatus, one that utilized a fresh underwriting team that Prosper recruited from Capital One, and each loan is now rigorously inspected before it is granted. As a result, Prosper’s lending volume – and the accompanying default rates – has decreased dramatically from its 2006-08 levels, as these graphs utilizing Prosper data demonstrate.

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