As a result, underwriting guidelines have tightened; fewer borrowers will qualify, fewer will refinance and more short sales and foreclosures will take place, affecting the value of surrounding properties. Consumers have less money to spend, and all of this further weakens a falling real estate market.
What Are Subprime Mortgage Loans?
A borrower's FICO score and loan-to-value ratio determine the type of loan a borrower will qualify for and, typically, low FICOs, coupled with high ratios such as 100% financing, result in subprime loans.
- Subprime loans carry higher interest rates than do conventional loans for higher-rated, A-paper borrowers.
- Certain types of subprime loans such as "no documentation" or "stated income" are funded at even higher interest rates, sometimes several points above traditional loans.
- Most are adjustable-rate mortgages.
FICO Score Qualifications for a Subprime Mortgage Loan
Until early 2007, lenders made subprime loans to borrowers who had FICO scores of less than 620. But those ratios are rising in the heat of the subprime market shake-out. Borrowers who once qualified with a FICO of 620 have watched the FICO requirements move to 640 and up. Those applying for 100% financing could once qualify with a FICO of 580, but that number has changed to 620, coupled with almost double-digit interest rate pricing. Today, except for VA, most lenders will not lend at all on 100% financing.
- Major institutional lenders like to see FICO scores above 700, and those borrowers receive the lowest interest rates and terms.
- Borrowers whose FICOs fall between 600 and 700 receive less favorable terms.
- Borrowers with FICOs below 600 are finding it difficult to obtain financing at any interest rate.
Tip: FHA loans do not require a FICO score and may be an option for borrowers hoping to refinance.
Subprime Mortgage Loan Features
The problem with subprime loans doesn't lie solely with subprime lenders. It's the product. Popular subprime loans were often 2/28 adjustable-rate mortgages or Option ARMs.
- A 2/28 works by qualifying the borrower at a fixed-rate for two years.
- Beginning with the third year, the rate changes and fluctuates over the remaining 28 years.
- Typically, rates can move 2 percentage points beginning in the third year, and adjust every six months.
- Common cap rates are 6 points over the initial rate, which means a loan taken out at 5% can reach 11%.
- Many 2/28 loans contain a prepayment penalty, adding insult to injury for those who want to refinance.
A Sacramento man bought a home in 2005 by taking out a 2/28 mortgage. After it closed, he called his lender to complain that he did not realize his mortgage payment could go up 2 points on his two-year loan anniversary.
To further complicate the situation, since the value of the home rose after one year of occupancy, the owner refinanced his mortgage into another 2/28 mortgage. He also rolled the costs of the mortgage into his loan and financed them, which increased his mortgage balance.
As the owner watched home prices in his neighborhood fall, he became depressed. It's easy to point fingers at the mortgage lender, but this borrower was advised by his agent not to refinance. His home is now worth less than he originally paid for it. What's worse is he owes 120% more than the value of his home.
The market value, if a home owner is not selling, is not a major consideration because home prices can fluctuate. It's a cycle. The problem arises when the loan adjusts, and the mortgage payment becomes unaffordable. The prediction is this home will go into a short sale situation.
Relaxed Underwriting Guidelines Hurts Home Owners
Early 2007, a borrower came to Fidelity National Title in Sacramento to sign loan documents. She was closing on her dream home. As the escrow officer explained to the borrower that her new PITI mortgage payment would be $2,500 per month, the soon-to-be home owner's jaw fell.
"But I take home only $2,500 per month," the borrower gasped. Apparently nobody explained to the borrower that she would be responsible for paying taxes and insurance. Those liabilities bumped her payment to $2,500 per month.
The escrow officer called the mortgage company to say she was refusing to notarize documents for this borrower and that Fidelity National Title would refuse to record the loan documents. I'd like to believe that all title companies would jump on this bandwagon and take appropriate action when the situation warrants. Certainly, if this loan had been funded, the borrower would have gone into default within 30 to 90 days. This loan should not have been approved through underwriting.
At the time of writing, Elizabeth Weintraub, DRE # 00697006, is a Broker-Associate at Lyon Real Estate in Sacramento, California.