March 22, 2004, Revised August 1, 2006, February 26, 2007, June 30, 2009
"I hear terrible things about subprime mortgage lenders. What are they
and how can I avoid them?"
Subprime Lenders Defined
A sub-prime lender is one who made loans to borrowers who did not qualify for
loans from mainstream lenders. Some were independent, but most were affiliates of mainstream lenders operating under different
names. I use the past tense because at the time of the most recent
revision of this article, virtually all sub-prime lenders had
disappeared.
Sub-prime lenders seldom if ever identified themselves as such. The only
clear giveaway was their prices, which were uniformly higher than those
quoted by mainstream lenders. Borrowers who qualified for mainstream financing
were sometimes induced to borrow from a sub-prime lender.
Subprime Borrowers Defined
A subprime borrower is one who cannot qualify for prime financing terms
but can qualify for subprime financing terms. The failure to qualify for
prime financing is due primarily to low credit scores. A very low score
will disqualify. A middling score might or might not, depending mainly
on the down payment, the ratio of total expense (including debt
payments) to income, and ability to document income and assets.
Some other factors can also enter the equation, including purpose of
loan and property type. For example, a borrower who is weak on some but
not all of the factors indicated in the paragraph above might squeak by
if purchasing a 1-family home as a primary residence. But the same
borrower purchasing a 4-family home as an investment might not make it.
Subprime Lending Terms
Sub-prime lenders based their rates and fees on the same factors as prime
lenders. For example, rates were higher the lower the credit score and
the smaller the down-payment. However, the entire structure of rates and
fees was higher at sub-prime lenders to cover the greater risk and higher
costs of sub-prime lending.
A higher percentage of sub-prime than of prime loans go into default.
Sub-prime lending costs are also higher because more applications are
rejected and marketing costs are higher.
Among subprime loans that don’t default, a higher percentage prepay
early. Prepayment penalty clauses were often mandatory, and a high
percentage of subprime loans had them. On the other hand, escrow of
taxes and insurance, which is required in the prime market unless the
borrower pays for a waiver, was usually not required in the subprime
market.
The 2/28 ARM
A very common mortgage in the subprime market, which I have never seen
outside of that market, is the 2/28 ARM. This is an adjustable rate
mortgage on which the rate is fixed for 2 years, and then reset to equal
the value of a rate index at that time, plus a margin. Because the
margins are high, the rate on most 2/28s will often rise sharply at the
2-year mark, even if market rates do not change during the period.
For example, the rate is 6% for 2 years but the index is currently 4%
and the margin is 6%. If the index remains at 4% after 2 years, the loan
rate will jump to 10%.
Some borrowers with poor credit scores took 2/28s at high rates, planning to rebuild their credit during the 2-year period. Their plan
was to
refinance at a better rate after 2 years. Even before the financial
crisis, this plan could be thwarted by a prepayment penalty that went
beyond two years, which some did; or by a
lender who failed to report their payment history to the credit reporting
agencies, which also happened. When the financial crisis erupted
in the fall of 2007, refinancing sub-prime loans became virtually
impossible.
The Problem of Prime Borrowers Getting Sub-Prime Loans
While it functioned, the sub-prime market made mortgages (and home
ownership) available to a segment of the population that otherwise would
have been shut out of the market. That was the good news. The bad news
was
that some borrowers who were eligible for loans from mainstream lenders
ended up in the sub-prime market. They were prime borrowers but they paid
sub-prime prices.
This happened partly because of the difficulties some borrowers can have
in determining whether or not they qualify in the mainstream market.
Underwriting requirements can differ from one mainstream lender to
another, so it is quite possible that a borrower with problems, who is
not eligible at one lender, will be eligible at another.
However, the main reason some prime borrowers ended up paying sub-prime
prices is that they were solicited by sub-prime lenders and went along with
the deal pitched to them without ever contacting a mainstream lender.
This is sometimes referred to as "steering". Very few sub-prime loan
officers would give up a commission by referring a qualified applicant to
a mainstream lender. The deal was much more likely go down at sub-prime
prices, regardless of how qualified the borrower might have been.
Sub-prime lenders marketed aggressively to home-owners who already had
mortgages. A major pitch was the cash that borrowers could take out of
their properties through a cash-out refinance. Another common pitch was
the lower payments possible on interest-only mortgages and option ARMs.
These lenders targetted groups and areas that promised to have many
sub-prime borrowers – usually lower-income neighborhoods.
Many occupants of such neighborhoods could have been prime borrowers but
by electing to go along with the soliciting firm, they paid sub-prime
prices.
A good general rule to prevent this from happening to you is never to respond favorably to a solicitation without first checking other
options. If you deal with only one loan provider, your prospects are
better if you make your selection by throwing a dart at the yellow pages
than by accepting a solicitation.
The really bad news is that when home prices started to decline in late
2006, sub-prime defaults soared, serving as the trigger for a global
financial crisis. See
Evolution of a Financial Crisis.