Sub-prime lenders seldom if ever identify themselves as such. The only clear giveaway is their prices, which are uniformly higher than those quoted by mainstream lenders. You do want to avoid them if you can qualify for mainstream financing, and I’ll indicate how shortly. 

There are lenders who offer both prime and sub-prime loans, and one of them is referred to below. For borrowers who aren't sure where they stand, dealing with a lender who offers both has a distinct advantage. They will try to qualify you for prime and only if that fails will they drop you to subprime. Lenders who are strictly subprime might refer a prime borrower to an affiliated prime lender, but their financial interest dictates otherwise.

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 base their rates and fees on the same factors as prime lenders. For example, rates are higher the lower the credit score and the smaller the down-payment. However, the entire structure of rates and fees is 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 are often mandatory, and a high percentage of subprime loans have them. On the other hand, escrow of taxes and insurance, which is required in the prime market unless the borrower pays for a waiver, is often 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 8% 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 take a 2/28 at a high rate and plan to rebuild their credit during the 2-year period. Their plan is to refinance at a better rate at that time. The major threat to such a plan is a prepayment penalty that runs past two years, which some do; and a lender who fails to report their payment history to the credit reporting agencies. Borrowers should be on their guard against both.

The Problem of Prime Borrowers Getting Sub-Prime Loans

The development of the sub-prime market has made mortgages (and home ownership) available to a segment of the population that otherwise would have been shut out of the market. That’s the good news. The bad news is that some borrowers who are eligible for loans from mainstream lenders end up in the sub-prime market. They are prime borrowers but they pay sub-prime prices.

This happens 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 end up paying sub-prime prices is that they are solicited by sub-prime lenders and go along with the deal pitched to them without ever contacting a mainstream lender. This is sometimes refer red to as "steering". Very few sub-prime loan officers will give up a commission by referring a qualified applicant to a mainstream lender. The deal will very likely go down at sub-prime prices, therefore, regardless of how qualified the borrower may be.

Sub-prime lenders market aggressively to home-owners who already have mortgages. A major pitch is the cash that borrowers can take out of their properties through a cash-out refinance. Another common pitch is the lower payments possible on interest-only mortgages and option ARMs.

These lenders target groups and areas that promise to have many sub-prime borrowers – lower-income black neighborhoods, for example. Many occupants of such neighborhoods will be sub-prime, but those who aren’t and who go along with the soliciting firm will pay sub-prime prices.

Here are some guidelines to prevent that from happening to you:

* Never 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.

* Check your eligibility for mainstream financing with mainstream lenders. The easiest way to do that is on-line. Some sites that I like for this purpose are Eloan.com, Amerisave.com, and NationalMortgageAlliance.com. These are all Upfront Mortgage Lenders.

* If you can’t qualify with any of them, your best bet is an Upfront Mortgage Broker (they are listed on my web site). They may charge sub-prime applicants a little more because they require more time. You will know what they charge, however, and you will know that you are getting the wholesale price posted by the lender, which means you won’t be exploited.

The Amerisave Commitment

In 2006, I made a deal with Amerisave, which offers both prime and sub-prime loans. Under the arrangement, I get paid for referring clients to Amerisave from my site, Amerisave discloses its markup over the wholesale price on all loans, and borrowers who can't be qualified except for subprime loans are charged the same markup as other borrowers. (Ordinarily, markups are higher on sub-prime loans because of the higher costs.) I don't get paid on these deals. Amerisave's fully disclosed prices, and the full terms of its arrangement with me, can be found here.

Copyright Jack Guttentag 2007