Subprime loans disappeared off of the market immediately following the housing crisis, but with the new mortgage guidelines and higher confidence levels of everyone in the industry, they are available again. You will find stricter guidelines and less flexibility in the programs than before, but they are available for those that need them in order to purchase a home. The good news is that the stricter requirements are not only for borrowers but for banks as well, which means that you will not be taken advantage of in the process – if a lender provides you with a loan, they have to do so with confidence that you can afford the loan after reviewing all of your income documentation rather than taking your word for it and giving you a No Income, No Asset loan.
Who Needs a Subprime Loan?
Many people shy away from the subprime loan because of its negative annotations. Today, they are not a negative program; in fact, they provide many people with the ability to purchase a home that would otherwise not have the chance to do so. Anyone can apply for this type of loan, but the people that need it the most fall into one of the following categories:
- Suffered a bankruptcy in the past few years
- Lost their home due to foreclosure
- Lost their job and their credit suffered as a result
- Collections or judgments still report on their credit report
Basically, anyone that suffered during the downturn the economy took is a good candidate for the subprime program. Conventional and FHA loans have some flexible guidelines, but they have strict waiting periods for bankruptcies and foreclosures and they also have minimum credit score guidelines everyone must follow. If you do not fall into that “perfect” category, subprime is the best option available to you. The downside of the subprime program is the higher interest rates charged, but the government has a general limit on what can be charged and to which borrowers. It is no longer a free-for-all in the mortgage industry – everyone has the necessary protection for a positive outcome overall.
Qualified Mortgages and You
If you do not have great credit and have several credit blemishes on your credit report, you might not fall into the Qualified Mortgage category. This is the category that covers standard FHA, VA, USDA, and conventional loans. The new rule monitors how much borrowers have to pay to get a mortgage the type of terms they receive, and the debt ratio each borrower has after obtaining a new mortgage. If a loan is outside the parameters set forth by the Qualified Mortgage rule, the industry considers it a non-qualified mortgage. This does not mean that you cannot get the mortgage; it simply means there is less protection surrounding the program. The good news is that the lack of protection is on the lender and not the borrower. With a Qualified Mortgage, borrowers cannot bring a lawsuit against the lender if they default on their loan. The QM rules state that the lender did his due diligence in determining if you could afford the loan. On the other hand, non-QM loans do not have this rule, but it does not mean the lender does not need to determine if you can afford the loan. Instead, subprime mortgages go by the Ability to Repay Rule.
The Ability to Repay Rule states, as the name suggests, that you can pay the mortgage back after the lender evaluates your financial profile. Every loan created for a borrower must meet the requirements of this rule. The lender must be able to prove beyond a doubt that you can afford the payments on the new loan. As of right now, there are not standards as to how the lender should qualify you for the loan, but the lender must have its own procedures to determine your ability to afford the loan.
Lenders do have standards and suggestions as to how they should determine your ability to afford the loan. The standards are pretty basic and would apply to almost any loan on the market, including FHA, VA, and conventional loans. First and foremost, lenders must evaluate your income, this includes your past, present, and future income. This is how lenders can determine what you can afford. When they look at your past income, they can determine a pattern. If your income is not consistent, it could serve as a red flag for the lender as to what your future income may hold. This could count against you, so making sure your income is consistent works to your benefit. Once the lender determines you have consistent income, he must determine the likelihood of your income continuing in the near future. This can be done with a Verification of Employment or the receipt of an award letter if you use social security or disability income to qualify for the mortgage. In addition to income, lenders need to evaluate your assets as they also tell a lot about your financial responsibility. If you do not have any liquid assets, you are a higher risk for the lender, so it works to your benefit to have some assets or reserves available. Last, but not least, lenders will use your credit report to determine your pattern for making payments as well as the amount of debts you currently have. If your debts amount to too much and do not leave you with an adequate amount of discretionary income, it could be hard to obtain even a subprime loan.
After looking at each of these scenarios, if the lender still feels you are a good candidate for a subprime loan, your loan passes the Ability to Repay Rule.
How Subprime Loans Differ
Subprime loans still differ from standard loans in many areas. Because they do not have to follow the Qualified Mortgage guidelines, they are free to charge prepayment penalties or create interest rate increases. Neither of these issues is bad, but you should make yourself aware of what they are and how they work so you can make the right decision for yourself.
If your subprime loan has a prepayment penalty, consider your future before you sign on the dotted line. If the home you wish to purchase is not your forever home, consider how long you will stay there. If it is not longer than the prepayment penalty period, then this loan is not for you as it will cost you a large amount of money to pay the loan off early. If on the other hand, you do not see yourself moving in the foreseeable future and you can afford the payment for as long as the prepayment penalty is in place, then there should be no reason to pay the loan off or refinance it, making it a suitable loan for you.
It is fairly common for subprime loans to be adjustable rate mortgages, rather than fixed rate mortgages. This means you will have a fixed rate for a specified period and then your rate will adjust at equal intervals. For example, if you have a 3/1 ARM, you will have an introductory rate for the first 3 years that is fixed and then your rate will adjust once per year after that. It is impossible to predict how much the interest rate will adjust, but every ARM has a cap, so if you figure out the maximum interest rate you could ever be charged, you can determine your future debt ratio and ability to afford the adjusted mortgage payment. If the highest adjustable rate is too high, you might want to consider another loan type that is more affordable for you.
Are you a Subprime Borrower?
You will not know if you have to succumb to the subprime loans or not until you have your loan profile evaluated. Generally, if you do not have consistent income, have a lower than normal credit score, have serious credit issues, such as a BK or foreclosure in your recent past, or are self-employed but do not have a two-year history, you will need a subprime loan. Remember, however, that this is not your forever loan; once you pass the prepayment penalty period, if your credit improved, your income became more stable, and you have at least 2 years of self-employment income to use for qualification purposes, you might be able to refinance out of the subprime loan. For now, however, think of it as a way to get into the home you wish to own. You can work on your credit and improve your payment down the road.
Justin McHood is America's Mortgage Commentator and has been providing expert mortgage analysis for over 10 years.