What Is a Sub-Prime Mortgage Lender?
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 targeted 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.

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