By Mike Heayn Real Estate 101
IN THE LAST FEW WEEKS, A LOT OF NEWS has come out about the subprime melt-down. However, people want to know if it will affect them. About one in five loans is a subprime loan.
But what is a subprime loan? Lenders, such as banks, have certain credit criteria that a borrower has to meet in order to receive a loan with a competitive rate. Obviously, not all borrower’s meet this criteria, but need an option for obtaining a loan, typically with less favorable terms. These types of loans are known as subprime loans. A subprime borrower usually has a credit score in the low 600 range. Per the 2001 Expanded Guidance for Subprime Lending Programs, “Subprime borrowers typically have weakened credit histories that include payment delinquencies, and possible more severe problems such as charge-offs, judgments and bankruptcies.”
Lenders over the last few years have continued to lower the credit criteria for subprime borrowers due to increased competition. This caused the subprime market to balloon due to easier borrower qualification. Many subprime borrowers received short-term fixed products that turn into adjustable loans.
The problem is that subprime loans are much riskier for lenders. Many lenders anticipate a certain level of default, but lately that default level has mushroomed to an even higher level. It is difficult to paint a clear, unbiased picture. On one hand, lenders are giving people an opportunity to own a home. On the other hand, the lender is charging a higher rate and offering terms that may not be advantageous for the borrower. For example, if a borrower came to a lender and did not meet the credit criteria for a market rate loan the lender may offer the borrower a loan with a higher rate. The borrower may be able to pay for the loan with the higher rate, but after two, three or five years that loan begins adjusting. If the borrower is just able to make the payment during the fixed period, when the loan becomes an adjustable the payment could raise 30, 40 or even 50 percent, making it impossible for the borrower to make the payment.
At the time of origination, the borrower may have thought that they would simply refinance. The problem is many of these sub-prime loans are turning into adjustable loans in the near future and the many property values have lowered. If you were a borrower that got a 100 percent financed loan and went to refinance, but learned your home is only worth 90 percent of what you paid, you would not be able to get out of the current loan without paying down a chunk of the principal.
This problem will only get worse in the near future and with rates continuing to move higher today, as compared to a few years ago, this will continue to play a big part in the real estate market. Also, subprime borrowers tend to default, or not make payments, on home loans more often than borrowers who meet the higher credit criteria. Each loan that goes into default means more capital reserves have to be placed aside by the lender. The more money the lenders have to place into a reserve account, the less money they can lend out. Many of the large sub-prime lenders in the news are not able to make new loans or even cover the losses from the current loans, forcing many of them into bankruptcy protection.
Today, there is talk on Capitol Hill about finding a solution for these subprime loans. It is possible the government may bail these homeowners out since no one wants millions of people losing their homes. The next few months may well be an interesting time in the political and economic areas. Many lenders are tightening their credit criteria and are preparing for the worst.
If you are a subprime borrower and making your next payment is becoming difficult, talk to the lender to see if they can help you avoid defaulting.
MIKE HEAYN is a Washington Mutual multi-family loan consultant. He (310) 428-1342 or
Originally published in the Santa Monica Daily Press print edition on March 28, 2007. Read the original PDF.