Subprime Lending


Subprime lending” is best defined as offering financing to an individual with poor credit, low income, or limited documentation, who generally wouldn’t qualify for a mortgage at standard market rates or at all.

If a borrower fails to meet the requirements of the traditional banks and lending institutions out there, they must resort to using a subprime lender who in turn will offer a higher interest rate in exchange for elevated risk. Seems fair.

In short, if you present a higher risk of default to the lender, you must pay a higher rate of interest to compensate. Unfortunately, this is a bit of a catch-22, seeing that more risky borrowers with even higher interest rates are more likely to default. Think about that for a minute.

As a general rule, a borrower with a FICO score below 620 would fall into the “subprime” category, also known as “B paper” or “near-prime”. This is the best definition of subprime. It’s pretty much credit score driven.

And if a consumer has a score this low, there is a good chance they have major derogatory accounts on their credit report, and/or possibly high credit utilization (maxed out credit lines).

Typically, a sub-620 credit score doesn’t just happen, and is usually the result of a collection, charge-off, bankruptcy, or another serious delinquency, such as a late mortgage payment, a short sale or foreclosure.

Tip: How to get a mortgage with poor credit.

Typical Subprime Loan Offerings

Subprime offerings include standard loan programs geared towards borrowers with low credit scores, insufficient income and/or a high debt-to-income ratio that aren’t able to qualify with traditional lenders.

These types of lenders may also offer loans with high loan-to-value ratios (LTV) and limited documentation, or a combination of the aforementioned that make for aggressive lending practices traditional banks may deem too risky.

In essence, you can get the same exact 30-year fixed or 5/1 ARM with a subprime lender or a prime lender, but the distinguishing characteristic will be the interest rate you receive.

Many subprime critics also consider interest-only loans, negative-amortization loans, and generally any non-fixed mortgage to be subprime, although that view is somewhat extreme and more opinion than fact.

Note: Some even characterize FHA loans as subprime, seeing that the minimum credit score is 500 and the max LTV is 96.5%. But because such loans are government-backed, they’re viewed as more regulated and thus safer than conventional offerings.

How Subprime Came to Be

So how did the subprime lending industry get its start? Well, as mortgage rates dropped and home buying became wildly popular, many prospective homeowners sought financing but were turned away from traditional banks and mortgage lenders. This created a new, extremely large demographic that was without financing. Enter opportunity.

Proponents of subprime lending realized the demand for homeownership and refinancing despite imperfect credit and jumped on this untapped customer base, offering similar, if not more aggressive mortgage programs at a premium.

These “subprime lenders” were able to find investors to sell the loans on the secondary market, even those with low FICO scores and limited documentation, despite the obvious risk.

The practice was justified because it allowed otherwise good borrowers with an imperfect credit history to receive home loan financing, which in theory is said to spur the economy and increase spending and employment rates.

Why Subprime Lending Worked

Subprime lenders and the secondary investors that backed them decided to take on more risk because of rising property values, as the risk was reduced two-fold.

First, with property values on the rise, subprime borrowers were able to gain home equity despite paying less than the fully amortized payment or interest-only payments each month because of the appreciation.

Secondly, lenders reduced their risk exposure because the rising market provided equity to the homeowners, which was enough collateral to refinance the loan to a lower payment option (or new teaser rate) to avoid foreclosure, or at the very least, sell the property for a small profit.

Unfortunately, this formula was clearly flawed, and once home prices stagnated and dropped, a flood of mortgage defaults and foreclosures hit the market. Now almost all secondary investors have backed out, leaving subprime lenders with no capital and a lot of closed doors.

Subprime lending was never short of critics. Many felt subprime lenders were acting as predatory lenders, offering risky mortgage programs at unreasonable costs, often pushing under-qualified borrowers into poorly explained loan programs such as option-arms and interest-only home loans, leaving them with mountains of debt.

Now these borrowers, who were essentially destined to fail, have few options to avoid foreclosure.

In late 2006 and early 2007, many of the largest subprime lenders closed shop, including Fremont, New Century, Ameriquest, and many, many more. Too many to list to be honest.

I’d add a list of subprime lenders, but there aren’t any left…here is a general list of closed lenders, many of them subprime.

Nowadays if you’re looking for a subprime loan, you can either check out government programs like the FHA or seek out a non-QM lender, the latter of which offers more accommodating financing alternatives.

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