Mortgage: Everything you need to know....and more!

Subprime Lending (page 2)

Types

Subprime mortgages

Like other subprime loans, subprime mortgages are defined by the financial and credit profile of the consumers to which they are marketed. According to the US Department of Treasury guidelines issued in 2001, "Subprime borrowers typically have weakened credit histories that include payment delinquencies, and possibly more severe problems such as charge-offs, judgments, and bankruptcies. They may also display reduced repayment capacity as measured by credit scores, debt-to-income ratios, or other criteria that may encompass borrowers with incomplete credit histories."

Subprime mortgage loans are riskier loans in that they are made to borrowers unable to qualify under traditional, more stringent criteria due to a limited or blemished credit history. Subprime borrowers are generally defined as individuals with limited income or having FICO credit scores below 620 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.

In contrast, the majority of borrowers that receive "prime" mortgage loans from Fannie Mae have a FICO score above 620, a debt-to-income ratio less than 45%, and a combined loan-to-value ratio of 90%.. While FICO scores have a median of 723 (meaning half of all Americans at the time of the statistic fell above this level and half below), a score of 620 is simply a point many financial institutions use a basic measure of moderate, yet manageable, risk. Having a debt-to-income ratio less than 45% means that no more than 45% of the borrower's gross income pays for housing and other debts, meaning the borrower is more likely to have the income necessary to make the required payments without subjecting the lender to increased costs associated with servicing and collecting delinquent accounts. The loan-to-value ratio simply means that the borrower's down payment is for at least 10% of the total appraised value of the property.

Although most home loans are not subprime mortgages, their numbers rapidly grew in the early part of the 21st Century. Subprime mortgages accounted for 9 percent of all mortgage originations from 1996 through 2004 and rose to about 21 percent from 2004 through 2006. Subprime mortgages totaled $600 billion in 2006, accounting for about one-fifth of the US home loan market.

As with other types of mortgage, various special loan features are available with subprime mortgages, including:

  • interest-only payments, which allow borrowers to pay only interest for a period of time (typically 5–10 years);
  • "pay option" loans, usually with adjustable rates, for which borrowers choose their monthly payment (full payment, interest only, or a minimum payment which may be lower than the payment required to reduce the balance of the loan);
  • and so-called "hybrid" mortgages with initial fixed rates that sooner or later convert to adjustable rates.

This last class of mortgages has grown particularly popular among subprime lenders since the 1990s. Common subprime hybrids include the "2-28 loan", which offers a low initial interest rate that stays fixed for two years after which the loan resets to a higher adjustable rate for the remaining life of the loan, in this case 28 years. The new interest rate is typically set at some margin over an index, for example, 5% over a 12-month LIBOR. Variations on the "2-28" include the "3-27" and the "5-25".

Subprime credit cards

Credit card companies in the United States began offering subprime credit cards to borrowers with low credit scores and a history of defaults or bankruptcy in the 1990s when usury laws were relaxed. These cards usually begin with low credit limits and usually carry extremely high fees and interest rates as high as 30% or more. In 2002, as economic growth in the United States slowed, the default rates for subprime credit card holders increased dramatically, and many subprime credit card issuers were forced to scale back or cease operations.

In 2007, many new subprime credit cards began to sprout forth in the market. As more vendors emerged, the market became more competitive, forcing issuers to make the cards more attractive to consumers. Interest rates on subprime cards now start at 9.9% but in some cases still range up to 24% APR.

In some situations, subprime credit cards may help a consumer improve poor credit scores. Most subprime cards report to major credit reporting agencies such as TransUnion and Equifax, but in the case of "secured" cards, credit scoring often reflects the nature of the card being reported and may or may not consider it. Issuers of these cards claim that consumers who pay their bills on time should see positive reporting to these agencies within 90 days.

Proponents

Individuals who have experienced severe financial problems are usually labeled as higher risk and therefore have greater difficulty obtaining credit, especially for large purchases such as automobiles or real estate. These individuals may have had job loss, previous debt or marital problems, or unexpected medical issues, usually unforeseen and causing major financial setbacks. As a result, late payments, charge-offs, repossessions and even bankruptcy or foreclosures may result.

Due to these previous credit problems, these individuals may also be precluded from obtaining any type of conventional loan. To meet this demand, lenders have seen that a tiered pricing arrangement, one which allows these individuals to receive loans but pay a higher interest rate and higher fees, may allow loans which otherwise would not occur. In 1999, under pressure from the Clinton administration, Fannie Mae, the nation's largest home mortgage underwriter, relaxed credit requirements on the loans it would purchase from other banks and lenders, hoping that easing these restrictions would result in increased loan availability for minority and low-income buyers. Putting pressure on the GSE's (Government Sponsored Enterprise) Fannie Mae and Freddie Mac, the Clinton administration looked to increase their sub-prime portfolios, including the Department of Housing and Urban Development expressing its interest in the GSE's maintaining a 50% portion of their portfolios in loans to low and moderate-income borrowers.

From a servicing standpoint, these loans have a statistically higher rate of default and are more likely to experience repossessions and charge offs. Lenders use the higher interest rate and fees to offset these anticipated higher costs.

Provided that a consumer enters into this arrangement with the understanding that they are higher risk, and must make diligent efforts to pay, these loans do indeed serve those who would otherwise be underserved. Continuing the example of an auto loan, the consumer must purchase an automobile which is well within their means, and carries a payment well within their budgets.

Criticism

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, Guaranteed Investment Certificates, etc. which are backed by the full faith and credit of the issuing country or institution. The same goes for loans. Less creditworthy subprime borrowers represent a riskier investment, so lenders will charge them a higher interest rate than they would charge a prime borrower for the same loan.

To avoid high initial mortgage payments, many subprime borrowers took 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 costing much more. So a $500,000 loan at a 4% interest rate for 30 years equates to a payment of about $2,400 a month. But the same loan at 10% for 27 years (after the adjustable period ends) equates to a payment of $4,220. A 6% increase in the rate caused slightly more than a 75% increase in the payment. This is even more apparent when the lifetime cost of the loan is considered (though most people will want to refinance their loans periodically). The total cost of the above loan at 4% is $864,000, while the higher rate of 10% would incur a lifetime cost of $1,367,280.

On the other hand, interest rates on ARMs can also go down — in the US, some interest rates are tied to federal government-controlled interest rates, so when the Federal Reserve cuts rates, ARM rates go down, too. Most subprime ARM loans are tied to London Interbank Offered Rate (LIBOR) - a rate trading system originating in Britain). ARM interest rates usually adjust once a year or per quarter, and the rate is based on a calculation specified in the loan documents. Also, most ARMs limit the amount of change in a rate. See Adjustable rate mortgages.

Mortgage discrimination

Some subprime lending practices have raised concerns about mortgage discrimination on the basis of race. The NAACP filed a lawsuit in federal court in Los Angeles against 12 mortgage lenders. The lawsuit accuses the companies of steering black borrowers into subprime loans. Black and other ethnic minorities disproportionately fall into the category of "subprime borrowers", even when median income levels were comparable, 46% of home buyers in the African American Neighborhood of Jamaica Queens, New York City received loans from sub-prime lenders while only 3.6% of those in a predominantly white Bay Ridge, Brooklyn received a loan from a subprime lender. Interest rates and the availability of credit are often tied to credit scores. The results of a study by the Texas Department of Insurance in 2004 found that of the 2 million Texans surveyed, "black policyholders had average credit scores that were 10% to 35% worse than those of white policyholders. Hispanics' average scores were 5% to 25% worse, while Asians' scores were roughly the same as whites." It should be noted that while this shows association (thereby demonstrating the possibility of the existence of ethnicity-based discrimination), it does not show causation.

Definition

The meaning of "subprime" changed during the last quarter of the 20th century. According to the Oxford English Dictionary, in 1976 a subprime loan was one with a below-prime interest rate; it wasn't until 1993 that the term took on its present meaning.

The American Dialect Society designated the word "subprime" as the 2007 word of the year on January 4, 2008.