How does foreclosure affect interest rates on loans?

Answer 1

The effects that foreclosure can have on interest rates of other loans needs to be examined from a few different perspectives. From a personal level, homeowners facing the loss of their homes may see an increase in interest rates on loans they already have, as well as any new loans they take out. But, from a macroeconomic point of view, large numbers of foreclosures can have even more detrimental effects to a society's ability to borrow, depending on how the situation is handled.

Many credit cards have clauses in them that, if a consumer defaults on any other loan, the credit card company can raise the interest rates. This can happen even if that particular line of credit is completely paid up to date and current. This has been one of the more devious methods by which creditors add in extra fees and bump up interest rates even if their client's account is not behind at all.

When homeowners face foreclosure, it is often due to a financial hardship, and the mortgage is the last bill that is defaulted. This means that homeowners may fall behind on on credit card initially, which raises the interest rates on all their other personal loans. Once they are unable to keep up with these any longer and the financial hardship has not ended, they finally fall behind on the house loan. The mortgage interest rate does not adjust higher due to missed payments, but interest begins to accrue on late fees and miscellaneous charges, thereby also increasing the effective rate homeowners would pay over the life of their mortgage.

Also, homeowners who face foreclosure will most likely have to deal with higher interest payments for several years after the situation has been resolved. Whether they are able to stop foreclosure before a house is lost or not, numerous late payments on a mortgage loan will drag down their credit scores severely. And the higher interest rates they pay on their existing credit cards will continue long after they have gotten back on track with these credit lines.

From a larger economic perspective, foreclosure rates can have a noticeable effect on general interest rates in several ways. Especially with the prevalence of Adjustable Rate Mortgages (ARMs) in the housing market, mortgages that adjust to higher rates have contributed to the high foreclosure rates.

As interest rates rose throughout the economy, it became more difficult to qualify for a mortgage at the same time that interest rates were resetting higher on existing mortgages. This had the effect of causing a severe decline in property values and a resulting credit crisis. So many mortgages have gone bad that it has become nearly impossible to figure out who owns these loans and what can be done about them.

The Federal Reserve has been lowering interest rates over nearly the past year in an effort to create more liquidity in the financial markets and alleviate some of the burden on homeowners. Interest rates are still resetting and causing mortgage payments to skyrocket, but they are smaller increases than they otherwise would be if interest rates were higher.

The already high foreclosure rates are also contributing to higher interest rates for new borrowers applying for mortgages. Lenders now know that giving out mortgages to people who had no income and did not put any money down was not the way to create lasting business. Lending standards have tightened dramatically, and banks are now requiring homeowners to put money down and prove that they can afford the mortgage.

But even this is somewhat counterproductive, as tighter lending means fewer people are able to qualify for mortgages, and property values need to decrease even further. Homeowners in foreclosure often find out that they are now underwater, owing more on their homes than they are worth. Borrowers, in order to qualify for loans at higher interest rates, are able to offer sellers less than if interest rates were lower; and the lack of qualified buyers in the market means that more properties will be available for sale. Homeowners who have to sell in this market environment may have to accept less or convince their lenders to accept a short sale.

So interest rates on loans can have dramatic effects on homeowners in foreclosure, both on a personal level and a larger economic level. Some of these effects homeowners may be able to avoid, but others will impact their ability to sell their house to avoid foreclosure or even find a buyer in time. They may also have to deal with significantly higher interest rates on their existing loans as well as more difficulties in borrowing again in the future.