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Fixed Rate Mortgages

Subprime loans, sometimes also called nonprime loans, are for clients with credit that has been damaged to the point where they can’t qualify for any FHA, VA, or conventional mortgage.

Bad credit happens. Lenders typically won’t make a mortgage loan to someone who simply doesn’t care about paying anything back whatsoever, but they do like to make loans to people who have temporarily had some type of financial disaster in their lives.

In the olden days, say in the mid-to-late 1980s, it used to be that someone who had bad credit would simply be shut out of homebuying altogether. The borrower would have to wait, sometimes as long as seven years or more, before a lender would make him or her a mortgage loan.

Now though, subprime loans make up nearly a quarter of all mortgage loans issued in the United States. And that number could be even higher if others tried to buy a home instead of not applying because of their own assumptions about loan qualification.

So how and when do you send the buyer to a subprime lender or provide a subprime loan?

First, don’t prejudge the client’s credit situation unless you’ve been in the business for a few years. Heck, don’t even do it then. The very first thing you should do after taking a loan application and running a credit report is to submit the loan to an automated underwriting system (AUS) to get a decision.

Let’s first use a little common sense here. If the client’s credit is really bad (i.e., the client’s FICO score is in the 500s and he has less than 20 percent down), don’t get too excited about providing a conventional loan. Go ahead first and try for an automated decision. If you don’t get the result you want, then take the next step and go subprime. Subprime loans can come in most any mortgage type, including fixed-rate and adjustable-rate programs, but most often the subprime loan of choice is the hybrid. Hybrid ARMs provide a fixed, belowmarket rate for the first few years then turn into an adjustable-rate loan that resets annually or periodically. Most of the subprime loans I’ve seen are either the 2/28 or 3/27 version of the hybrid.

The trick with subprime loans is to understand specifically what they’re designed for. They’re designed to help your clients get back on their feet and into homeownership. With a subprime loan, your clients will want to do everything they can to repair and reestablish their credit scores. One of the best ways to improve a score is to make mortgage payments on time. This can be done with a subprime loan.

It can take two to three years of responsible credit history to improve a credit rating. By getting a subprime loan, a borrower can reestablish his or her credit by the time the initial hybrid period ends and then refinance into a lower-rate conventional loan.

Don’t think of a subprime loan as a bitter pill your borrowers must swallow due to their credit situations. They should instead see the loan as ‘‘mortgage medicine’’ that will help them get better soon. Sure, subprime loans come in many flavors, but their rates can be 2–4 percent higher, or more, than conventional loans. The trick with subprime loans is to take the hybrid, pay close attention to the credit patterns, and refinance your clients out of the higher-rate loan as the hybrid adjusts. Subprime ARMs can have some pretty nasty margins, some as high as 5 percent or more.

You don’t want your client’s interest rate to jump from 6.00% to 11.00% after the first 36 months. The subprime loan is a Band-Aid and is not to be used for the rest of his or her life. Also make sure that if you plan to refinance the client later on that you are being realistic. You should realize that if a subprime loan is the only loan the client qualifies for at the time of application, then the client won’t be in a position to refinance until after two or three years anyway. That’s about how long it will take to reestablish good credit, which is necessary before you can refinance into a fixed-rate conventional mortgage.

Most subprime loans carry, where allowed, a prepayment penalty as well. If the loan has a prepayment penalty, I wouldn’t worry about it too much. Most prepayment penalties coincide with the fixed portion of the hybrid ARM. For example, if your borrowers have chosen a 3/27 hybrid, the prepayment period will usually last three years, or two years on a 2/28. Most loans of this type also offer the option of ‘‘buying out’’ the prepayment penalty either in points—usually one year of buyout will cost one-half to one percent of the original principal—or by increasing the rate. If your client buys out one year of the prepayment penalty, the client can anticipate a quarter-point rate increase for each year bought out.

On a side note, it’s very important your clients not pay discount points when taking a subprime loan. A discount point is a fee equal to one percent of the loan amount, and for every point paid up front, the lender reduces the interest rate on the loan. If the goal is to refinance in two to three years, then it doesn’t make any sense to pay a fee to get a lower rate—the client won’t be keeping that subprime mortgage long enough to garner the full benefit of the lower rate.

For example, a $300,000 subprime loan may be offered at 7.50% for a 2/28 hybrid. That works out to a $2,097 monthly payment. Remember that the goal is to refinance in 24 months after the client has repaired his credit. The lender offers to reduce the rate to 7.00% if you pay two points, or $6,000. That’s a common spread.

The monthly payment using 7.00% on $300,000 is $1,995. Yes, the monthly payment is now over $100 lower. But your clients paid $6,000 for that privilege. It will take them 59 months ($6,000 divided by $100) to recoup that money. If in 24 months they refinance into a conventional loan, they would have saved just over $2,400 but in effect lost $3,600 because they ‘‘bought down’’ the rate.

There are ‘‘zero-point’’ subprime loans just as there are zero-point conventional or FHA loans. Keep the loan costs low on a subprime loan if the goal is to refinance after a short period or right at the end of the hybrid term. The math rarely works out.

Subprime loans offer more variables than conventional or government loans do. Although a conventional loan might offer 5.50% on a 30-year fixed with 10 percent down, most likely that’s the rate offered if the borrower put 20, 30, or even 40 percent down. But not with subprime loans. Subprime lending makes allowances for different variables:

• Down payment
• Debt ratios
• Credit scores

A subprime lender will offer better deals if any of those three variables are adjusted. Still even better if all three are improved.

For example, let’s say that the client’s credit score is 590, his debt ratios are at 50%, and the lender’s minimum down payment is 10 percent. You might get a 2/28 subprime offering of 8.00%. But if you put down 20 percent instead of 10, the rate might be reduced another quarter point.

If the client chooses to put down more money, say 30 percent, which also reduces the debt ratios further to 44, you’ll find that the rate might go down further—perhaps by another percent.

Subprime lenders are fairly strict about such guidelines. You’ll see that on their rate sheets. In these cases, credit scores, loan-to-value ratios, and debt ratios are in fact set in stone. In subprime lending, the rate in fact goes up by a quarter point if the borrower’s credit score is 589 and not 590, or if the debt ratio is 46 instead of 45. Unlike conventional lending, which rarely has such requirements, subprime lending doesn’t allow for many exceptions.