Understanding subprime mortgage loans: What you need to know

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Subprime mortgage loans benefit those with less-than-perfect credit

Subprime mortgage loans are loans made to people with less-than-perfect credit—people with FICOcredit scores below 620. The reasons why people have a low score varies. Intermittent employment, illness, poor financial decisions, high level of borrowing, inconsistent payment history, and no credit history, can produce a low credit score.

Subprime loans when properly originated can offer a second chance to many to resurrect their financial life.

Subprime loans charge higher interest rates in order to offset the anticipated higher loss rates numerically reflected in the borrowers’ FICO credit scores. Lower scores indicate that the borrower’s ability or willingness to repay the loan is less likely than another borrower with a better FICO score.

A borrower with a better FICO score will qualify for conventional financing and lower interest rates.

Some credit unions will make subprime loans but without the subprime predatory lending practices.

Before you borrow any money from any lender, you need to determine whether they are a predatory lender or not. If the borrower is not financially sophisticated, predatory lenders may engage in a practice known as interest rate steering. The lender sets the rate on what the lender thinks the borrower will accept rather than on the rate borrower would be entitled to based on the borrower’s FICO score. The Center for Responsible Lending notes, “Studies show a significant percentage of subprime borrowers could qualify for mainstream mortgage loans.

Many predatory brokers/loan officers receive a “yield spread premium” (YSP) when they negotiate a loan with a much higher interest rate. The mortgage broker or loan officer receives a cash bonus when the loan is signed. The higher the interest rate, the bigger the cash bonus—kickback paid to the mortgage broker or loan officer. Some brokers or lenders remit this payment to the borrower in order for the borrower to pay the closing costs on loans. Unbelievably, there is no legal requirement to disclose to the borrower the relationship between the YSP and the interest rate charged on the loan.

The Center of Responsible Lending cites the double whammy a subprime borrower suffers when a YSP is included in the subprime mortgage. “The vast majority of borrowers in the conventional mortgage market can pay off their mortgage anytime they choose without incurring a penalty. However, subprime loans commonly feature prepayment penalties, especially loans that include a YSP. Because lenders who pay a YSP want to make sure they recover the cost of the kickback, they have added incentive to impose prepayment penalties. These penalties—which typically cost several thousand dollars—pose a significant obstacle to families who establish good credit and want to refinance to get a loan with better terms.

Because YSPs encourage prepayment penalties, these kickbacks not only make loans more expensive from the beginning, they also effectively penalize borrowers for developing good credit over time.”

Shockingly, YSPs are included in 85 to 90 percent of all subprime mortgages according to The Center for Responsible Lending.

from the Oct. 17-23, 2007, issue

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