Subprime Mortgage Loan

A subprime mortgage loan is a product that charges a higher interest rate and higher fees than a prime mortgage. People with low FICO scores have a difficult time qualifying for traditional mortgages so the subprime market developed to provide a means for these people to purchase homes. FICO stands for Fair, Isaac Corporation, the company that calculates a numerical value for an individual's creditworthiness. Though the actual formula is a trade secret, it is based on such factors as employment and residential stability, record of meeting financial obligations, and amount of available credit. The three major reporting agencies, namely, Equifax, Experian, and TransUnion, also have their own formulas for determining creditworthiness, but the FICO is considered the industry standard. A low FICO score almost always represents someone who hasn't done a good job paying bills. (People who pay cash for everything are the rare exception. They may not have a FICO score at all.) A prime lender is unwilling to take the risk that the potential borrower will make monthly house payments. But the person may qualify for a subprime mortgage loan.

The subprime or non-prime market offers loans to people with poor credit histories at interest rates that are higher than a prime loan. The higher interest rate reflects the additional risk that the subprime lender is taking by lending money to someone with poor credit. Additionally, the fees on a subprime mortgage loan are higher because of the higher risk and because of increased marketing costs. At least, that is how the industry justifies the increased costs of its loans. Anyone with a mailbox knows that the industry markets aggressively in their search for potential borrowers. Promotional materials often encourage property holders to refinance for a higher amount than is owed on the first mortgage. By taking cash out of the home's equity, the marketing campaign announces, the homeowner can consolidate other debts or take a dream vacation. At one time, such advertisements even encouraged people to borrow up to 125% of a home's appraised value. The tide has turned, though, and after the falling housing market, legislation has been passed that has tightened the underwriting and disclosure requirements. With the new legislation, consumers will be better informed about the details of a subprime mortgage loan before they sign their name to the dotted line.

People with low credit scores aren't the only ones who have been caught up in the subprime market fiasco. A potential mortgage applicant who knows she has an excellent FICO rating is confident in applying for a loan through a prime lender. But someone with a middle score may not have this same confidence. Instead of shopping around, he may apply for a subprime mortgage loan and get caught with high interest rates and poor terms. But he may have been eligible for a prime mortgage since the prime lender looks at other factors in addition to the FICO rating. These include the size of the down payment, the ratios of house payment to gross income and total monthly debt to gross income, and the willingness and ability to provide additional documentation. Though it may take longer for someone with a FICO score in the middle range to be approved by a prime lender, the cost savings will be enormous. Even a one percent difference in an interest rate can increase a monthly payment by hundreds of dollars and practically all of that, at the beginning of the term, is going to pay the interest, not the principal. Over the life of the loan, the additional amount paid may be well over $100,000. Knowledge and good sense are financial protections. "When wisdom entereth into thine heart, and knowledge is pleasant unto thy soul; Discretion shall preserve thee, understanding shall keep thee" (Proverbs 2:10-11).

A popular subprime mortgage loan was a product called the 2/28 ARM (adjustable rate mortgage). The product started out with a fixed rate (which was still higher than the prime market) for the first two years of the mortgage. Typically, the interest rate adjusted upwards after the first two years and every six months after that with a cap of about 6%. This means that, given time, a mortgage that started out with an 8% interest rate could increase to a whopping 14%. As the rates went up, people found they couldn't continue making the monthly payments. They might attempt to refinance to a lower rate with better terms only to find out that there was a prepayment penalty for paying off the loan early. Meanwhile, the housing market began declining and the house was no longer appraising as high as it once did. Selling at a profit was no longer an option. As more and more people found themselves in these types of situations, the housing market continued its downward spiral. Banks began foreclosing and the property values continued to drop. Because of this recent crisis, the legislation was passed to give consumers more upfront information about the subprime mortgage loan documents they are asked to sign at closing.

Financial experts suggest that potential borrowers begin shopping for loans with prime lenders. Even someone with a middle FICO rating may have the opportunity to explain the legitimate reasons for late payments found in her credit report (illness, temporary job loss, etc.). Different lenders have different underwriting requirements. Just because the applicant is turned down by one prime lender doesn't mean that another lender won't approve the application. An applicant who qualifies for a prime rate, but applies for a subprime mortgage loan will probably be given the subprime rate. The lender may not tell the applicant he is eligible for a lower interest rate because of the commission that will be lost. Consumers should be aware that a little time spent shopping and comparing now can save a them a great deal of money and stress in the future.

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