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The expression financial crisis broadly applies to a number of cases in which the vital financial assets rapidly lose a great proportion of their nominal value. During the nineteenth and twentieth centuries, numerous financial instabilities have a high link to banking panics and numerous recessions coincided with the panics. Other circumstance often referred to as financial instability consists of stock market crashes and bursting of other money bubbles, currency instability as well as sovereign defaults. Financial instability directly leads to a great loss of paper affluence but hardly result in adjustments within the real economy (Dwyer, 2009).
Different economists and scholars often offer hypothesis about how financial instability grows and how to prevent the undesirable condition. However, there lacks consensus and financial instability continue to be witnesses occasionally. This paper will describe the nature, causes and probable solutions of the major financial crisis experienced in the United States between 2008 and 2012. The paper also addresses the fine details of the crisis highlighting on some issues such as; questions of who was responsible for the undesirable financial condition. Some basic theories relating to the cause of the challenge. The public policies applicable to deal satisfactorily with the identified causes. Some steps taken by congress and Obama government to deal with the matter, and lastly whether the adopted measures were effective or not.
Nature of the crisis
Firstly, the great recession has a direct link with the major banking crisis witnessed during the period. Bank in the entire United States were suffering massive and rapid withdrawal of financial by depositors; a phenomenon known as a bank run. In all the cases, banks and financial institutions lend out majority of the funds they collect in forms of deposits (Dwyer, 2009). Therefore, it was challenging the same institution to back swiftly all the deposits while being demand at once. The occurrence results to a situation where clients lose their deposits. This was to the extent that insurance deposits hardly covered them. Banking panic or systematic banking crisis is a situation in which major financial institutions face runs. Banking crisis was not very eminent during the United States great recession, but it fairly characterized the financial instability.
Secondly, the 2008 crisis was characterized with speculative crashed and bubbles. Witnessing of a speculative bubble is during an even of massive, sustained and persistent overpricing of various classes of assets. A major factor that facilitates the occurrence is the availability of customers who buy an asset based mainly on the speculations of reselling the same asset at a better price, as opposed to computing the revenue the asset will create in the future. In the event that a bubble is experienced, risk of a crash is eminent, as well.
A crash is a situation in which price of assets are conflicting and hence customers will only proceed with the purchase if they expect other market participants to purchase. In such an event, a large proportion might decide to sell causing a fall in prices. Nevertheless, it is quite challenging to make a prediction on whether a financial asset price will actually equate to its fundamental value. Therefore, it is difficult to determine the reliability of the bubbles. Some economists and scholars insist that bubbles never experienced during the United States during the recession. However, all indications show that the situation was almost getting to that level (Nanto & Library of Congress, 2009).
The third characteristic of the great recession was the international financial crisis. For a country that uses the fixed exchange rate, a situation may arise when the financial sector is compelled to devalue the currency of the nations to accommodate speculative attacks. This state of affairs is the balance of payment instability or a currency crisis. In case the state is unable to settle its foreign financial debt, this phenomenon is sovereign default. It is important noting that, at times, both devaluation and default might be because of a voluntary decision by the administration. However, state of affairs emerges as the inevitable consequences of adjustments in financial investor decision that results to a prompt stop in capital returns or an unexpected rise in capital flight. Largely these circumstances described the situation during the great recession in the United States.
Wider economic crisis
Negative gross domestic product growth that extends beyond two quarters is a recession. A substantially severe or prolonged recession often turns out to be a depression. On the other hand, a prolonged period of sluggish but not certainly negative growth in GDP is economic stagnation. Economists during the U.S crisis believed that the undesirable situation was because of financial instability. Some economist and scholars, however, believed that the recession led to financial challenges and not the vice versa. The argument is that in cases where financial crisis act as the initial disturbance that initiates a recession, other components might be more crucial in prolonging and worsening the recession period (Nanto, & Library of Congress, 2009).
Causes of the financial crisis and their consequences
1. Strategic complementary within the financial markets.
Arguments exists that successful and efficient investment demands that each market participant in the financial market to predict the intentions of the other investor. Soros George, a great American economist, described this necessity to predict the aspirations and intentions of the other market investors as reflexivity. On the same note, John Maynard Keynes, a 1930s economist, compared a financial sector to a beauty competition game, where participants attempts to guess the model other players in the contest will consider extremely outstanding. Self-fulfilling prophecies and circularity may be overrated when reliable data is not accessible because of partial disclosures or lack of disclosure altogether.
Moreover, in numerous cases market participants are motivated to coordinate their individual choices. For instance, an investor who feels that other market players are willing to purchase a certain currency in masses may anticipate that the value of that other currency will go up. As such, the investor is also enticed to buy the same currency in anticipation of making high returns. Similarly, a depositor in a certain bank who anticipates that other depositors will withdraw their finances may predict collapsing of a bank and, therefore, he/she may have an incentive to withdraw his investment, as well. Scholars describe the drive to mimic the plans of other investors a strategic complementarity.
Economists and financial analysts argue that if firms and individuals portrays a sufficiently powerful incentive to imitate the actions of the other market players, then there is witnessing of a phenomenon called self-fulfilling prophecies. For instance, if a firm feels that the value of a certain currency will go up, this may result to the eventual rise in its value. Alternatively, if a bank depositor anticipates that the bank will deteriorate, the bank may surely fail. Therefore, there is a perception that financial instability behaves like a vicious circle where investors avoid some financial assets or institution anticipating that others will shun them, as well. This was the case in America during the great financial crisis of 2008.
Leverage, in the financial sector means acquiring investment’s funds through borrowing. There is a frequent assumption that excessive borrowing is the contributor of the financial crisis in America. When an individual or financial institution only invests their own funds, they can in the extremely worst scenarios, lose their own cash. However, when there is borrowing of the better part investment’s funds, the firms and individuals can potentially gain more from their investment but they can lose in excess of what they own, as well. Therefore, borrowing investment funds augments the potential gains from investment, but generates a bankruptcy threat, as well (Dwyer, 2009).
Since the bankruptcy implies a situation where an individual, a firm or a country fails to settle all its financial obligations to lenders, it may extend financial challenges from party to the other. The average level of leverage to an economy usually grows before a financial crisis arises. For instance, borrowing to fund investment within the stock market become increasingly and amazingly common following the 1929, Wall Street Crash. Additionally, some scholars and economists have suggested that financial institutions might fuel fragility by smacking leverage, and thereby fueling the underpricing of risk. Leverage was a major contributor to the instabilities experienced in 2008 in American continent.
3. Asset-liability mismatch
Asset-liability mismatch is another factor argued to have fueled the undesirable financial market in the United States. Witnessing of this phenomenon is where the risks linked to the firm’s assets and debt appear inappropriately aligned. For instance, commercial bank provides deposit accounts to clients. There can be frequent withdrawal of these accounts and the bank utilizes the gains to provide long-term loans to homeowners and businesses (Nanto & Library of Congress, 2009). There is a perception that the mismatch exhibited between short-term liabilities to the banks and the bank’s long-term assets is the main reason why bank run phenomenon arises. Similarly, in 2007-2008 Bear Stearns in U.S. failed because it failed to renew the debt it had used to fund long-term projects in mortgage securities. This case due to the mismatch of assets and liability
In a global context, numerous emerging market administrations fail to sell bonds denominated in their domestic currencies and hence sell which are denominated in the United States dollar instead. This tendency leads to a discrepancy between their assets and denomination of currency of their financial obligations. This results to a threat of sovereign default occasioned by the instabilities in the exchange rate. This mismatch between assets of the United States’ federal government and its liabilities contributed to the instabilities experienced in the continent during the 2008 recession.
Numerous analyses of financial instabilities emphasize on the role of investment errors occasioned by inadequate knowledge or imperfection in the reasoning of individuals behavioral finance analyses mistakes in quantitative and economic reasoning. Torbjorn Eliazon, an American psychologist, has as well analyzed inadequacies in economic reasoning within the oecopathy concept. Historians, markedly, Kindle Berger Charles has shown those crises often appear after massive technical or financial innovations. According to Charles, this is because such innovations present investors and businesspersons with fresh forms of commercial opportunities, a phenomenon that he referred to as displacements of the expectations of investors. Early similar cases consist of 1720, Mississippi and South Sea bubble, which emerged when the idea of investment in company’s stock was unfamiliar and new to many. Another example is the 1929 crash that came after the introduction of improved transportation and electronic technologies.
Recently, numerous financial disabilities followed improvement in the environment of investment facilitated by financial deregulation, as well as the fall of dot com bubble early 2001 arguably started with irrational exuberance regarding internal technology.
Unusuallness in the recent financial and technical innovations may assist in explaining how individuals and institutions often overrate the value of their assets. Also, if the initial investors in a fresh class of assets make profits from value of assets as other market participants familiarize themselves with the new innovation, then more others are likely to imitate the trend. This will gradually drive the market price notably higher as others rush to purchase in anticipation of similar gains.
If such trend forces prices to go up far beyond true asset value, a crash becomes exceedingly inevitable and hence the undesirable consequences. If for whatever reason the price slightly falls, so that firms perceive that there is no guarantee of additional profits, then the upward trend may take a reverse route, with the price reduction occasioning an urgency of sales, fueling the fall in prices (Nanto & Library of Congress, 2009). This uncertainty led to the worsening of the 2008 financial crisis in United States.
5. Regulatory failures
The United Stated administration had attempted to mitigate or eliminate financial instability by regulating and restricting the operations of the financial industry. One key objective of this behavior was to ascertain that there was observation of transparency in the sector. Its execution was mainly through making firms financial circumstance acknowledged publicly through ordering regular reporting performed under standardized accounting approaches. Another major aim of institution’s control was to make sure that firms had sufficient assets to settle their commercial obligations, through capital requirements, reserve requirements and other restrictions on leverage.
Nonetheless, some financial instability has a link with the insufficient control. In addition, it has occasional adjustments in regulation procedures to evade a repeat. For instance, Dominique Strauss-Kahn, the former IMF Managing Director blamed the financial challenge of 2008 on control measures’ failure to safeguard against extreme risk-taking within the financial system, particularly in the United States. Similarly, New York Times media house indicated that the major cause of the instability was due to credit default swaps’ deregulation.
However, excessive restriction is associated with intensifying the state of the financial crisis. In specific, the famous Base II Accord was criticized for demanding banks to expand their capital base when risks manifests, which may cause them to lower lending particularly when capital is in low supply, potentially worsening the financial crisis.
There is global regulatory merging interruptions leading to regulatory herding, worsening marketing herding and so aggravate systematic risk. From that perspective, upholding dynamic regulatory regimes may act as a safeguard.
Fraud and embezzlement of funds have contributed to the fall of some financial organs, when firms have enticed depositors with misleading assertions about their unique investment plans, or have misappropriated the resulting income. Good examples include, the fall of the 1994 MMM project in Russia, the 20th century Charles Ponzi scam at Boston, the 1997, Albanian Lottery uprising scam and more recently the fall of Madoff Investment in 2008 (Dwyer, 2009).
Numerous rogue merchants that have occasioned huge losses at the commercial sector have been associated with fraudulent acts in a desire to hide their merchants. Scam in mortgage funding was also cited as one probable contributory factor to the subprime mortgage crisis of 2008. Government executives indicated on 23 September 2008 that FBI was investigating the matter to identify the probable scam by mortgage funding firms Lehman Brothers, Freddie Mac, American International Group and Fannie Mae. Similarly, there are suggestions that numerous financial institutions were negatively affected by the 2008 crisis because their respective managers did not perform their fiduciary duties sufficiently.
Contagion is an expression used to illustrate the idea that financial instabilities may extend from one firm to another, for instance, when commercial banks run spread from several banks to various banks or from one nation to another, for instance, when currency instabilities, stock market or sovereign defaults crashes spread across nations. When the failure a particular financial body risks the stability of numerous other organs, the phenomenon is systemic risk.
One extensively cited case of contagion was the intensive spread of the 1997 Thai Crisis to other nations like South Korea. Nevertheless, economists and scholars usually debate whether observing instabilities in various nations is certainly occasioned by contagion from a single market to various market, or it was instead occasioned by similar underlying challenges that might have affected each nation individually even in the devoid of international linkages.
7. Recessionary effects
Some financial instability has limited effect beyond the financial domain, like the 1987 Wall Street crash, but there are assumptions on other instabilities to be contributors of derailing growth in the other sectors of the economy. Different theories attempt to explain why a financial instability might have caused a recession in the other sectors of the economy. The hypothetical ideas consist of flight to quality, and financial accelerator, Kiyotaki-Moore model, and the flight to liquidity. Some 3rd generation replicas of currency disaster explore how banking and currency crisis can combine to occasion recessions experience like that of 2008 (Nanto & Library of Congress, 2009).
Theories Explaining Financial Crisis
Recurrent massive depressions and recessions in the international economy at a rate of twenty and fifty years have been the subjected to various analysis. This is so since Charles Jean provided the initial hypothesis of crisis that aimed at criticizing the classical political economy principle of equilibrium between demand and supply. Generating an economic instability theory became the main recurring ide throughout Karl Marx’s work.
In a capitalist economy, operational firms return less cash to their employees than the value output. The revenue first covers the initial capital invested. However, in the end it appears that the money returned to the population is less than the amount required to purchase all goods produced. The viability of Marxist hypothesis depends on two factors: firstly, the population size that is in the working class category and amount of tax that returned to the masses by the government in the form of family benefits, welfare and education and health spending (Dwyer, 2009).
Hyman Minsky proposed a post-Keynesian illustration that is most appropriate when dealing with a closed economy. Hyman hypothesized that financial fragility signifies a typical trait of all capitalist economic systems. High fragility results to adverse threat of financial instability. To support the analysis, Minsky gives three tactics the financing companies may select, according to their degree of risk tolerance. These include Ponzi finance, hedge finance and speculative finance.
After the recession, companies choose only hedge because it is the safest. During the recovery, firms select speculative financing. Finally, boom firms have much confidence in their financial capability and hence they choose Ponzi financing. However, this is where trouble starts because firms have taken huge loans and some of the starts. Lenders, on the other hand acknowledge the risks in the financial sector halt giving funds so easily (Dwyer, 2009). Refinancing proves impossible for borrowers and more companies default. Unless there is, injection of fresh money into the economy to facilitate refinancing a real economic problem begins. During the recession, firms start to hedge again, and the cycle is closed.
Mathematical techniques of modeling monetary crises have portrayed that there is positive feedback between decisions of market participants. Positive feedback means that there might be dramatic adjustments value of assets in response to minor changes in the fundamentals of the economy (Joseph, 2008). For instance, some representations of currency crises imply that a static exchange rate might be stable for an extended period, but will crash abruptly in the fall of currency auctions in reaction to an adequate decline of government funds or fundamental economic conditions.
According to diverse theories, positive feedback means that it is possible to attain several equilibrium points. There might be an equilibrium where investors spend comprehensively in asset markets due to the expectations of a rise in value of such assets. However, there might be another equilibrium level where investors flee asset markets due to fear of others freeing the market. This is the sort of argument underlying Dybvings and Diamond concept of bank runs, where investors withdraw all deposits because they fear that others will do the same (Dwyer, 2009). Similarly, in Obstfeld's doctrine of currency instability, when conditions are constant, two possible outcomes are eminent: speculators may decide to attack the domestic currency or they may choose not to attack depending on the expected reactions of the speculators.
To deal with the crisis and to avoid history from repeating itself, the government of United Kingdom led by President Barack Obama must implement two policies. One is credit control and the other one is money supply regulation. Through central bank, the government can order commercial banks to reduce credit lending (Halm-addo, 2010). This can be achieved through increasing lending rates, selective credit control and increasing cash reserve ration. About money supply reduction, the government must reduce its activities to ensure excess money is not supplied into the economy.
The steps that the government and the congress would have implemented to drive the economy out of the recession include reduction in excessive taxation to create demand and reduction of public dept. The government and the congress failed to implement these policies and hence the recession continued to oppress the economy. For instance, high taxes reduced demand hence low profits for the firms. High public debt attracted high level of capital outflow hence causing a negative balance of payment.
In conclusion, the congress and the government failed to the appropriate policies of reducing taxation and public debt. As a result, recession continued until the market forces regulated the economy. Therefore, it is clear that the government and the congress are to blame for the financial crisis that destabilized the American economy.
Dwyer, G. P. (2009). The financial crisis of 2008 in fixed income markets. Atlanta, Ga.: Federal Reserve Bank of Atlanta.
Halm-addo, Albert D. (2010). The 2008 Financial Crisis: The Death of an Ideology. Dorrance Pub Co.
Nanto, D. K., & Library of Congress. (2009). The global financial crisis: Analysis and policy implications. Darby, Pa: Diane Publishing.
Joseph, L. (2008). The finance crisis and rescue: What went wrong? why? what lessons can be learned?. Toronto: University of Toronto Press.
The U.S Treasury has over the past decade borrowed trillions of dollars, much of it from the foreign investors, in order to finance two major wars, to boost the financial system of the U.S as well as to stimulate the economy to continue expanding. The ability of the country to borrow has been restated by the statute, and the Congress has been called upon to authorize the issuing of new debt space (Masters, 2013). In May 2013, the federal government reached the climax of its borrowing and in the absence of new borrowing the Treasury has been forced to take extraordinary measures in order to meet the financial obligations. The U.S has always been able to increase the debt limit with ease, which has made most economists to predict that the government will plunge into default and precipitate severe crises of finances (McCarthy, 2014). The government has to ensure that it can issue new debt as long as it is running budget deficient. The debt limit sets the maximum amount which the government can incur by law. Although increasing the debt limit does not necessarily enlarge the nation's commitments, it however ensures that the government can fund. its obligations.
Hitting the debt ceiling would easily paralyze the government's ability to finance its operation, which include providing for the national defense, as well as funding entitlements such as Social Security. Normally, the government would easily auction the debt in the form of government securities called the Treasury bills so as to finance the annual deficits (Masters, 2013).
Senator Pat Toomey points out refusing to have debt ceiling would not result in a default that would be a financial catastrophe to the U.S. He argues that such a default can only be caused by a reckless administration. The senator continues to maintain that the country does not have to experience default so long as the Treasury secretary makes the right call (Masters, 2013). In case the government refuses to increase the debt limit, the federal government is still going to can run its service delivery programs smoothly. In the coming years, more than 7 percent of most of the projected federal government will be pushed to the interest on our debt. The revenue that, is accrued through taxation covers at least 70 percent of all the government expenditures (McCarthy, 2014). Therefore, under any circumstances, there would plenty of money enough to have the creditors paid. In addition, the Treasury secretary himself has the discretion on the bills that, they could pay first in the event that there is a shortage of cash. Therefore, the Treasury secretary is the only one who can decide the fate of the financial situation by making a decision to default on the debt of the nation if the debt ceiling is not raised upon reaching it or to have a payment priority index to determine who gets paid t such situations
Economists are still trying to figure out the cost of last year's debt-ceiling crisis. This is the time when the Republicans refused to have a raise of the limit on U.S government borrowing unless the government had enacted sharp spending cuts.
The Government Accountability Office has shown that, delays in raising the limit of the debt led to some slight increase in the amount of borrowing for the U.S. The cost of the Treasury was more than 1.3 billion 2011, and the price tag continues to expand as the time progresses. At the current rates of spending as well as taxation, the federal receipts cover not more than 74% of the federal outlays. If the government happens to hit the debt ceiling, the total outlays will be inclusive of everything ranging from Social Security benefits to the pay o soldiers to interest on the national debt which will have to be trimmed by more than 26% immediately (McCarthy, 2014). Therefore the Obama administration would be facing a huge task of choosing those to get paid and those not to. Shall the government pay the soldiers in contingence? Does the government pay retirees who are dependent upon Social Security checks? Does it pay the taxpayers who are waiting to be refunded or the workers who participated in various tasks of the government?
The government relies heavily on borrowing in order to repay the existing debts; raising the debt ceiling would prevent default on these payments. On the other hand, raising the ceiling would result in America's first default ever, which the leaders of the financial community strongly believe that it would be disastrous (Masters, 2013). It would be very unfortunate to allow the U.S default since its debt plays a very major role in the world finance as well as the trade. This may severely erode the confidence of the financial system, which would consequently cause panic in the financial markets around the world.
Delays in the debt limit are likely to create uncertainty in the Treasury market and thus lead to higher borrowing costs. The delays in the debt limit in 2011 resulted increment of the cost of borrowing for the treasury at about $ 1.3 billion in the fiscal year 2011. This is however independent of the multiyear effects on the increased costs for the Treasuries securities that, would remain outstanding after the fiscal year of 2011(Masters, 2013).
Most of the experts agree that the potential threat f debt-limit problem is much greater and deeper as compared to most of a shutdown especially when given the risk of government default which is likely to jeopardize the creditability as well as the credit of the U.S. The impact of the shutdown, leads to citizens temporarily being denied certain government services, and is limited to the symbolic message of that it presents on the markets.
Masters, J. (2013). U.S. Debt Ceiling: Costs and Consequence. .Retrieved from http://www.cfr.org/budget-debt-and-deficits/us-debt-ceiling-costs-conseq...
McCarthy, A. C. (2014). Don’t raise the debt ceiling. National Review-the Corner .Retrieved from http://www.washingtonpost.com/blogs/wonkblog/wp/2012/07/23/gao-debt-ceil...
Mortgage Loan and Refinance Trap
As the residential rates of mortgaging nearing 30-year lows, many homeowners are rushing to refinance their mortgage debts. The advertisements cry out that refinancing is more than a "no-lose" pre-position for sure, some of the lenders have offered to refinance the debts without any cots which will affect the borrower (Irwin, 45). Lost in the hoopla of refinancing- the cost to the borrower of the losing his statuary immunity from the liability of the individual on their mortgage debt. This loss of the immunity may as well lead to people thinking twice on having to refinance their mortgage debt.
The anti-deficiency trap
In the typical situation of a residential loan, a bank or any other institution lends the bulk of money which is required for the purchase of homes in exchange for a promissory note for an amount and a trust deed (Irwin, 23). The trust deed refers to an instrument which is very similar to a mortgage transforming the home to a collateral form which could secure payment of the borrower's loan. In case the borrower happens to default in their payments of the debt, the trust deed maintains that the bank is allowed to repossess the home; forgo the interest in the home as well as sue the borrower for all the amounts which he owes to the bank. The trust deed also allows the bank to be able to repossess the home of the borrower and in addition take the borrower to court for all the inefficiencies costs. A deficiency is considered to be the total amount which is owed by the borrower's prommissory note less the value f the market of the home being reposed.
In spite of the language that is contained in most deeds of trust having indications of an otherwise probability, an anti-deficiency statues prohibits lenders from holding borrowers personally responsible for their home loan debt , as long as the four of the following factors listed below are present.
1. The loan is secured but a deed of trust which is lodged against the residence;
2. The residence has been used as a one or a two family residence
3. The residence is located in a more than two and a half acres sizes
4. The loan proceeds are actually used to pay for the entire home's purchase price.
In case a couple buys a single family home that is located on less than two and half acre size. They pay $ 5000 of their own money towards the price of purchase as well as finance the balance of the cost of the home throuugh a loan fro a bank (Wyly, 67). The bank needs the couple e to get a promissory note and sign the document for the amount lent and a deed of trust, which gives the bank the privilege of a senior security interest in the couples newly purchased home. In such a case scenario, the bank is the only recourse if the couple goes against its agreement on their monthly home loan obligations and requirements to take the possession of the home owned by the couple legally. The bank could not release the interest on the home and sue the couple for the whole amount owing ton their promissory note, nor sue the couple for any cases of deficiency between the value of the repossessed and the amount that is owed by the promissory note.
However, in case the couple in the example never defaults their original obligations of the mortgage, but instead refinances the debt because interest rates are more favorable. In such a case, the loan which replaces the couple's original loan is not being used to pay all or just some part of the home's price of buying the home. Consequently, under a iteral reading of the controlling anti-deficiency statutes, if the couple defaults on their obligations of refinancing, the lender who is refinancing the couples debt could waive the interest in the couple's home as well as sue them for the full amount of their mortgage debt. In other terms, the refinancing lender could as well respond by repossessing the home through judicial foreclosure as well as sue the couple for any deficiency caused, The refinancing lender is thus able to hold the couple liable for any full amount wing to their promissory note even if the refinancing lender is just the same lender which financed the initial purchase of the home.
The refinancing of a mortgage affects' the net worth of one in several ways
The payback period
Calculations of the simple payback period, is one of the common methods which is used in economics behind refinancing of (Pritchard, 23). The equation is made through his calculation of the sum of the monthly payment savings which can be realized through the refinancing of the monthly payment savings at a much lower rate and determining the month in which the sum cumulative sum of the monthly payments is greater than the cist if refinancing (Pritchard, 22).
Refinancing affects your household's net worth
The simple payback period method ignores the household's balance sheet total net worth equation; this is because there are two major things which are not accounted for.
The main balance of the existing mortgage in comparison with the new mortgage is ignored most of the times. The cost of refinancing heads to be paid back out of the pocket, and in most cases, are rolled into new mortgage principals balance (Pritchard,12). When the mortgage balance increases, through are finance transaction, the side of the liability of the household balance sheet also increases ,and all other factors kept constant, the household not worth immediately by a similar amount as that of refinancing (Pritchard, 11).
Refinancing a 30-year old mortgage with 25 years left until is paid off into new; 30-year mortgage means that one might lead to paying more total interest over the life of new mortgages even when the mortgage rate could be less than what one could pay in 25 years.
Lack of True Costs of refinancing
A more financially sound method of determining the economics of refinancing is the one which incorporates the true cost of refinancing into the households net worth equation, by comparing the amortization rate of the mortgage which is existing against the amortization schedule of the new mortgage (Wyly, 42). The amortization schedule includes the sorts of refinancing in the principal balance. (If the cost of refinancing will be paid out of the borrower's pocket, then the same dollar amount should be deducted from the existing mortgages' principal balance (Pritchard, 21). On the basis of the assumption that the refinancing transaction does not occur, the money could be used to pay the principal balance of the existing loan.)
From there, subtract the monthly payment savings between the two mortgages from the new mortgages principal balance. (As a result of the fact that, in theory, one could use the monthly principal savings from the refinancing to reduce the principal balance of the new mortgage)The month in principal customized of the new mortgage is much lower mortgage which is existing is the month in which a truly economical refinancing payback period on the net worth has been reached or arrived on (Pritchard, 15).
Home mortgage refinancing mistakes
Home mortgage refinance can save you money and could easily get you into trouble with money (Nielsen 23). The lure which is given by the lower interest rates as well as the monthly payments may look very attractive, but one has to fully understand the risk which comes with the same: In general one should avoid refinancing mortgages that could end up wasting their money and increasing the amount of risk. The following are the common mistake which occur during mortgage refinancing
Extending a loan's term
When one refinances, you often extend the amount of time you'll repay the loan. For instance, if you get 30 year loan, payments are calculated to last for the next 30 years (Nielsen 23). If your old loan only had 10 to 20 years left to go, home mortgage refinancing would result in higher interest payments. When you have a new loan, most go the payments goes towards the repayment of the loans for the early years, and one has to start from scratch.
The home mortgage refinancing costs money you'll pay fees to new lender so as to compensate them of the offering loan (Nielsen 30). You may also pay for the legal documents as well as fillings credit checks, appraisals, and many more.
Another strategy which you could sue for refinancing is the consolidation of debts. Sometimes this helps since you reduce interest are on your debt, and you could be able to turn consumer debts into tax-deductible home equity debts ((Nielsen 34). This is however easy to backfire due to the following reasons:
Simply shift the debt and rebuild your consumer debts again. (Nielsen 24).
Are unable to get any tax benefits from mortgage financing.
Recourse of the debt
In some states, home loans have special protections from the creditors. In the event of their foreclosure, they may not be able to sue you if they lose money on the deal (Nielsen 27). However, home mortgage refinancing changes the nature of one's loan: it's no longer the original loan one used to purchase their home, so there is a likelihood do loosing some level of protection.
The hidden trap in HARP refinancing
Refinancing through HARP is able to extend the length of time you have to carry on the mortgage four a long time in a very significant manner. Private mortgage insurance (PMI) can also make it very difficult to refinance through HARP, and limit the choices of the lenders-meaning that one could end up paying a higher rate than it is necessary.
If one is in the market for a HARP refinance, one is likely to think that they are going to be stuck with the PMI for a long time anyway. After all, having little or no home equity means that one is pretty far from the 80 percent loan-to -value ratio if the calculations are done based on the PMI to be cancelled on their mortgage.
The automatic PMI Cancellation Based on Original Home Value
Most homeowner's do not realize that federal law requires that PMI be removed automatically for most of the borrowers when their balance on their loans falls to 78 percent of the original value of their home. This is true even if their home has fallen in terms of value so that one has an advantage on their mortgage.
In addition to this, many more borrowers who bought their homes in the years which were just before the holding bubbling burst are approaching that vital point progressively/ typically, it takes 5-9 years to reach the 78 percent mark on a 30-year loan, depending on the amount of the initial down payment.
The biggest problem is that when one does not do a HARP refinance with PMI, one is likely to go back to the start as far as the automatic cancellation is concerned. Instead of having ones loan cancelled when they reach 78 percent of the original home value, one can now have to wait until it falls to 78 percent of the new balance (Warren, 123). This is likely to take about 10 years if one goes with a 30-year loan, since one is not getting head start from a down payment at that specific time but inky about four if one opts for a 15 -year term.
Refinancing can be harder, more expensive with PMI
The other factor is that PMI is likely to make it harder to get approved for a HARP refinance, or limit the options for choosing a lender. The biggest issue would be finding a lender who will do a HARP refinance on loans which are covered by private mortgage insurance (Kobliner, 202). Borrowers with PMI often get stuck with their current mortgage service, as opposed to having to shop around to different lenders to find the best rate. Borrower who are capable of shopping around for lenders are usually able to save at least a quarter of a point in their rate of mortgage (Warren, 178).
However, HARP has become a less obstacle to a HARP refinance since the new "HARP 2.0" guidelines took total and full effect recently (Ambrose, 78). The Mortgage Insurance Companies of America, an umbrella firm for the private insurers. reports that HARP is able refinance with PMI up to 88 percent in the quarter of 2012, when compared to other previous years.
Deciding whether to wait or refinance now
Borrowers need to take into considerations that carrying PMI for a longer time and the possibility of paying higher rate , as well as accounting for the possibility of morgage rates might rise as they are waiting for PMI to be set free.
What to avoid when refinancing
While refinancing a mortgage could offer a lower monthly payment as save money, there are many mistakes as well as traps which should be avoided (Nielsen 37). Mistakes which could cost, not just thousands of dollars, but could ultimately result in foreclosure if the homeowner is not necessarily careful (Nielsen 25). The following are the common mistake which should be taken care of;
Beware of the pre-payment penalty
Borrowers should be very keen on the mortgage companies since they may include some pre-payment penalties in the loan contract (Nielsen 28). This are normally offered as a small clause in the contract and may require that the penalty payment is enforced if the property is refinanced or sold prior to the specified home (Kobliner, 28). Most lenders do not however insert penalties for the pre-payment sin the contract, there are some less than reputable lenders that can impose excessive penalties.
Never Agree on Arbitration
Another clause which may be in the contract is the Arbitration clause. Arbitration is able to allow for a third party to be bought in order to resolve disputes which the borrower may have with the lender (Nielsen 12). This allows for the protection as well as the rights to be granted to the owner of the home. However, agreeing to an arbitrator will result in most of that process forfeited. This could prove to be a very expensive error in the future and therefore should be avoided at all costs.
Be careful of the high interest rates
Homeowners can often be misguided by less reputable lenders of mortgages who attempt to lure those with good credit into accepting lands which are bad (Nielsen 12). The purpose is to ensure that they charge high fees as well as rates thus make money. By comparing different lenders however, the homeowners are able to make informed decisions by taking the fairest arte of interests. This exercise is important in getting to learn the lenders who should be avoided in the long-run.
Review the good faith statement in the contract before signing.
It is very important t review the charges on the Good Faith Statement. Overpayment could be easily avoided by having a closer look into the fees. The origination fee should be less than the range of 1-1.5%. The loan of processing the fee should be less than $400. Other fees in the name of courier fees, applications fees, lock fee as an administration fees should not be paid for.
Understand the reasons for refinancing
Homeowners have various reasons for refinancing. Some just seek to reduce their rates of interest (Nielsen15). This may however not always be the case as some the fees which are related to the refinancing may be more than the gains which are accrued from the same exercise. In order to make the best decision, it is important to know the reasons for refinancing (Nielsen 23). There are a number of reasons among them; home improvement, consolidation of the debt or for a major purchase. It could also be due to some other personal financial reasons, which include taking loans o to purchase a car(V, Gazman, 18).
Be aware of the risk of foreclosure
Predatory mortgage lenders often request the borrower's to sign incomplete documents, or exaggerate the income level. This is done in order to promote default and it is also very dishonest. The borrower then qualifies for a larger property that they are able to comfortably finance. When they are not able to pay the lender, the lender forecloses and takes the home. It is very important for the borrower to carry out the necessary research on the offers of the mortgages so that they are able to recognize dishonest mortgage lenders and thus avoid them.
Irwin, Robert. Tips and Traps When Mortgage Hunting. New York: McGraw-Hill, 2005. Print.
Warren, Carolyn. Homebuyers Beware: Who's Ripping You Off Now?-What You Must Know About the New Rules of Mortgage and Credit. Upper Saddle River, N.J: FT Press, 2010. Print.
Warren, Carolyn. Mortgage Ripoffs and Money Savers: An Industry Insider Explains How to Save Lauer, Chris. Underwater: Options When Your Mortgage Is Upside Down. Dordrecht: Springer, 2014. Internet resource.
Kobliner, Beth. Get a Financial Life: Personal Finance in Your Twenties and Thirties. New York: Simon & Schuster, 2009. Print.
Ambrose, Brent W, and James N. Conklin. "Mortgage Brokers, Origination Fees, Price Transparency and Competition." Real Estate Economics. 42.2 (2014): 363-421. Print.
Wyly, Elvin K, Mona Atia, Holly Foxcroft, Daniel J. Hamme, and Kelly Phillips-Watts. "American Home: Predatory Mortgage Capital and Neighbourhood Spaces of Race and Class Exploitation in the United States." Geografiska Annaler: Series B, Human Geography. 88.1 (2006): 105-132. Print.
V, Gazman. "Arrhythmia of the Leasing Market." Problems of Economic Transition. 54.2 (2011): 60-74. Print.
Nielsen, B. (2014). How Morgage Refinancing affects Your Net Worth. Investopaedia .
Pritchard, J. (2014). Home Mortgage Refinancing Mistakes. about money .
Thousands on Your Mortgage or Re-Fi. Chichester: John Wiley & Sons, 2011. Internet resource.
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