Subprime loans originally had a bad rap, especially after the housing crisis with a large percentage of those loans gone bad being part of the subprime industry. Today, however, they are making a comeback. You might not find it as easy to obtain this type of loan as you once did, but they are still available for those borrowers that are willing to work for them.
Subprime Loans are for those Starting Over
Homebuyers that need a fresh start in their financial life are finding that they need subprime loans. These are the people that have less than stellar credit scores, little reserves, and foreclosures/bankruptcies to overcome. They want to be homeowners again but are finding that they are running up against a brick wall in the conventional and government sponsored world of lending. Even those borrowers that do end up qualifying for FHA loans often opt for the subprime mortgage simply because of the high mortgage insurance fees that FHA loans often include. People that have been through a rough time financially are not looking at the interest rate that they must pay – they are looking at the new chance at having a loan and owning a home. They consider it a turning point in their lives, knowing that their credit will improve with timely payments of their new subprime mortgage, enabling them to refinance into a lower rate at some point in the future.
Ability to Repay Rule
One thing that is vastly different about the subprime lending industry this time around is the monitoring that they undergo. While subprime loans do not fall under the Qualified Mortgage rules, which are put in place to protect banks from loans that borrowers default on; they are subject to the Ability to Repay Rule. This rule states that the lender has done its due diligence in determining that the borrower can beyond a reasonable doubt comfortably afford the new mortgage. This includes principal, interest, taxes, and insurance payments. There are not any particular underwriting rules pertaining to this new statute; it is up to the lender’s discretion on how to determine if the borrower is capable of affording the loan, but they make it in the lender’s own interest to do so. Despite there not being any written rules on the topic, there are some areas that lenders are strongly encouraged to know a lot about including:
- Full evaluation of current and proposed future income
- Full evaluation of assets
- Verification of current employment status
- Determination of monthly debts including court ordered debts (alimony, child support)
- The full debt to income ratio and the separate front and back-end ratios
- Credit history
If lenders can prove beyond a reasonable doubt that the borrower can afford the payment after evaluating each of the above items, it is thought that the loan passes the Ability to Repay Rule.
The real term to describe subprime loans today is non-qualified mortgages. These are the mortgages that don’t fall under the QM guidelines, which state:
- The points or fees on the loan do not exceed 3% of the loan amount
- There are no risky terms of the loan, such as interest only payments; balloon payments; or negative amortization
- The loan term does not exceed 30 years
- The debt ratio does not exceed 43%
This is not to say that the subprime mortgages that are created are not worthy of your time; it means that they are a little riskier than those that fall under the Qualified Mortgage guidelines. Lenders are still required to ensure that you have the ability to repay the loan whether or not it falls under the QM guidelines. Lenders must still do the following to ensure every step is taken to keep you informed:
- Monthly statements must easy to understand and show the use of previous payments, any upcoming rate changes, and any fees that were or are going to be charged
- Payments must be credited the day they are received
- Contact must be made with you in person if you hit more than 36 days late on a payment
- Plenty of notice must be provided with interest rate changes
Know What you are Getting
The basic rule of thumb when it comes to subprime loans today is to know what you are getting into. Because these loans are less restricted by government monitoring than Qualified Mortgages, you will have a little more risk involved. This is not to say that the loans are bad; you simply need to prepare yourself for what is ahead by simply talking to your lender and/or reading the paperwork and all fine print. Look for things like:
- Pre-payment penalties – These penalties are less common, but they do still exist for non-qualified mortgages. Make sure you are aware of the time frame and the penalty that is involved. Think of your future plans and whether or not you see the penalty being an issue. If you plan on moving in the next few years, typically a subprime loan is not the best choice as most of them will require a penalty for paying them off early.
- Interest rate hikes – Most subprime mortgages are adjustable rate mortgages. You might have an affordable rate in the beginning; say for the first 3 years, but after that the rate will likely increase significantly. Make yourself aware of how much the potential change could be to see if it will still work with your current finances. Typically, you don’t want to commit any more than 50% of your gross income to your mortgage payment – think of that when figuring your future payment.
The Typical Subprime Borrower
So what does a typical subprime borrower look like? There is no mold that creates that type of borrower; what it includes is those that do not meet the conforming guidelines such as:
- Borrowers with long-term, stable employment
- Borrowers with consistent income
- Self-employed borrowers with at least a 2 year history of the business
- Borrowers with excellent credit (over 700 at a minimum)
- Borrowers with a low debt-to-income ratio (28/36)
- Borrowers with a large down payment (at least 20%)
The typical subprime borrower may meet one or two of the above requirements, but not all of them. Maybe their credit is blemished because of a past job loss that made them lose their home, suffer a bankruptcy, or just have many late payments on their credit report. In other cases, it could be a borrower that was forced out of his job because of downsizing and ended up opening his own business. He makes a good income now, but because he does not have the 2 year, stable history, his income is not able to be used for qualifying purposes on a conventional or FHA loan. These are just a few examples of those that would be considered subprime. It does not necessarily mean a “bad” borrower nor is it something anyone should be embarrassed about. What subprime loans are right now is a bridge between not owning a home and having a conventional loan. It gives borrowers a chance to make up for past issues and to move their financial life forward.
The ultimate goal is for borrowers to be able to refinance out of a subprime loan after a few years. Once the prepayment penalty expires and there is a history of timely mortgage payments for several years in combination with more of a self-employed or even employed by an employer history, things will look brighter for borrowers, enabling them to get more favorable financing terms in the end.