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Chapter 8 |
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SUBPRIME
LOANS Subprime
lending, also called B-paper,
near-prime, or second chance lending, is the practice of making loans to
borrowers who do not qualify for the best market interest rates because of
their deficient credit history.
The phrase also refers to paper taken on property that cannot be sold on
the primary market, including loans on certain types of investment
properties and certain types of self-employed individuals. Subprime
lending is risky for both lenders and borrowers due to the combination of
high interest rates, poor credit history, and adverse financial situations
usually associated with subprime applicants. A subprime loan is offered at
a rate higher than A-paper loans due to the increased risk.
They can be used for borrowers with good or excellent credit when
their particular circumstances do not fit within normal underwriting
guidelines. However, over the
past year underwriting guidelines for these products have tightened
dramatically and Subprime Loans have become very difficult to find.
They were also considered to be a major contributor to the
“Credit Crisis” and “Mortgage Meltdown” that have negatively
affected our industry. Subprime
lending encompasses a variety of credit instruments, including subprime
mortgages, subprime car loans, and subprime credit cards, among others. The term "subprime" refers to the status of the borrower
(being less than ideal), not the interest rate on the loan itself. Subprime
lending is highly controversial. Opponents have alleged that the subprime
lending companies engage in predatory lending practices such as
deliberately lending to borrowers who could never meet the terms of their
loans, thus leading to default, seizure of collateral, and foreclosure. In
the The
controversy surrounding subprime lending has expanded as the result of an
ongoing lending and credit crisis both in the subprime industry, and in
the greater financial markets which began in the Subprime
lending evolved with the realization of a demand in the marketplace and
businesses providing a supply to meet it.
With bankruptcies and consumer proposals being widely accessible, a
constantly fluctuating economic environment, and consumer debt load on the
rise, traditional lenders are more cautious and have been turning away a
record number of potential customers.
While there is no official
credit profile that describes a subprime borrower, most in the United
States are supposed to have a credit score below 620. Statistically,
approximately 25% of the population of the United States falls into this
category. Capital
markets operate on the basic premise of risk versus reward. Investors
taking a risk on stocks expect a higher rate of return than do investors
in risk-free Treasury bills, which are backed by the full faith and credit
of the To
access this increasing market, lenders often take on risks associated with
lending to people with poor credit ratings. Subprime loans are considered
to carry a far greater risk for the lender due to the aforementioned
credit risk characteristics of the typical subprime borrower. Lenders use
a variety of methods to offset these risks:
These
increased fees compound the difficulty of the mortgage
for the subprime borrower, who
is defined as such by their unsuitability for credit.
Due to the risk profile of the subprime borrower, this access to
credit comes at the price of higher interest rates. On a more positive
note, subprime lending (and mortgages in particular), provide a method of
"credit repair"; if borrowers maintain a good payment record,
they should be able to refinance back onto their mortgages before the
tie-in has expired. A professional Loan Officer should be able to provide
information about the costs of switching mortgages and should always
explain to the borrower in great detail the “fine print” of the loan
product they are receiving. Generally,
subprime borrowers will display a range of credit risk characteristics
that may include the following:
1) Late payments paid sixty (60) or ninety (90) days past their due date
during the last thirty-six (36) months.
Excessive thirty (30) day late payments within the last twelve (12)
months will significantly reduce ones credit score and must be carefully
considered; 2)
Judgments, foreclosure, repossession, tax liens, or non-payment of
a loan in the last forty-eight (48) months; 3) Bankruptcy in the last
seven (7) years; 4) Relatively
high default probability as evidenced by, for example, a credit bureau
risk score (FICO) of 620 or below on a scale that ranges from 300 to 850. Subprime
mortgage loans have a much higher rate of default than prime mortgage
loans and are priced based on the risk assumed by the lender. Unfortunately,
many subprime mortgages have also been borrowers who lack legal
immigration status in the United States. There
are many different kinds of subprime mortgages,
including:
2.
"Pick a Payment"
loans (or option ARMs, where borrowers choose their monthly payment (full
payment, interest only, or a minimum payment which may be lower than the
payment required to reducing the balance of the loan). 3.
Initial fixed rate mortgages
that quickly convert to variable rates. This
last class of mortgages has grown particularly popular among subprime
lenders since the 1990s. Common lending vehicles within this group include
the "2-28 loan", which offers a low initial interest rate that
stays fixed for two (2) years after which the loan resets to an adjustable
rate, changing every six (6) months or once a year, for the remaining life
of the loan, and in this case twenty-eight (28) years. The new interest
rate is typically set at some margin over an index, for example, 5% over a
six (6) month or twelve (12)-month LIBOR (London Interbank Offered Rate,
which is the index). Variations
on the "2-28" include the "3-27" and the
"5-25". To
avoid the initial hit of higher mortgage payments, most subprime borrowers
take out adjustable-rate mortgages (or ARMs) that give them a lower
initial interest rate. But with potential annual adjustments of 2% or more
per year, these loans can end up charging much more. For
example, a $500,000 loan at a 4% interest rate for thirty (30) years
equates to a payment of about $2,400 a month. But the same loan at 10% for
twenty-seven (27) years (after the adjustable period ends) equates to a
payment of $4,470. A
6-percentage-point increase in the rate caused slightly more than an 85%
increase in the payment and an actual increase of $2,070/mo! Here are
some characteristics which have been applied to subprime loans. Every
buyer should consult with a lender to examine their individual
circumstances and make sure they understand all the parameters of any
particular loan especially subprime
lending! The guidelines in the current market are ever changing and
subprime program availability may even be outdated at the time of this
Mortgage Financing Guide publication:
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