How Subprime Mortgages Work

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If you've paid attention to the news over the past year, then you no doubt heard a great deal of talk about the housing boom and potential bust in the United States. There are many factors that helped give rise to the boom. One was the use of tricky lending programs that enable people with shaky credit ratings to secure home loans. This same practice has contributed equally to the bursting of the housing bubble.

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Many people need subprime mortgages to break into the housing market. See more real estate pictures.

The practice of lending money to people with a weak or limited credit history is called subprime lending. One misconception about the term "subprime" is that it refers to the interest rates attached to the loans. "Subprime" is actually a reference to the credit rating of the borrower. Subprime borrowers generally have a credit rating below 620 on a scale of roughly 300 to 900. Most consumers land in the mid- to high 600s and 700s [source: Bankrate.com].

Subprime rates can vary wildly. They're based on a variety of risk-based factors including:

Credit score
Size of down payment
Number of delinquencies (credit hits)
Type of delinquencies

The sharp rise in subprime mortgage lending began in the mid-1990s and accounted for roughly 20 percent of home loans in 2006 [source: Federal Reserve]. On the plus side, subprime mortgages allow people with poor credit a chance to get into a market previously unavailable to them with standard home loans. The downside of this scenario is that these loans are more likely to go into default, meaning that the borrower fails to make payments on the loan. The large number of foreclosures from subprime mortgages has had a drastic impact on the U.S. housing bust and overall economy. Lenders have also been hit hard, with many working in the red and some going under completely.

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Another negative aspect of the subprime market is the rise in accusations that lenders target minorities -- a practice known as predatory lending. These lenders prey upon the inexperience of the borrower in many ways. They may overvalue your property, overstate your income or even lie about your credit score in order to set sky-high interest rates. They also encourage frequent refinancing to get a "better" rate, and then roll the high closing costs in to the loan.

Subprime Credit Cards

Another way subprime lending rears its ugly head is in the credit card industry. Subprime credit cardholders can expect to pay a variety of additional fees not typically found with prime cards. Yearly fees, up-front fees, and higher late and over-the-limit fees are common.

The late payment grace period is also usually not available to a subprime cardholder. One fee typically leads to another -- the grace period isn't allowed, resulting in a late fee that's figured into the balance, leading to over-the-limit fees.

The system itself seems geared toward making money off the people that had financial difficulties to begin with. If you have a subprime card, it's very important to stay on top of your payments for an extended period. This way, you may actually be able to improve your credit.

In this article, we'll look at some examples of subprime mortgages to help you determine if one might be right for you. We'll also examine the subprime crisis and what's being done about it.

Subprime Specifics

Subprime mortgages come in all shapes and sizes. The one factor that's generally consistent across the board is that the interest rate will be higher than the prime rate established by the Federal Reserve. The prime rate is what lenders charge people with good credit ratings.

One of the more common subprime loans has an adjustable-rate mortgage (ARM) attached. ARMs have become increasingly popular in recent years due to their initial low monthly payments and low interest rates. Introductory rates for ARMS typically last two or three years. The rate is then adjusted every six to 12 months and can increase by as much as 50 percent or more [source: Bankrate.com]. If you hear about a 2/28 or a 3/27 ARM, the first number refers to the number of years at the introductory rate, the second to the remaining period of the loan with the fluctuating rate.

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Wells Fargo is a leading lender for home loans.

Interest-only options are also often attached to subprime ARMs. Let's look at a 2/28 interest-only ARM. This loan allows you to pay only on the interest during the two year introductory period at a lower set rate. After that, the full amount of the loan is recalculated over the remaining 28 years with a new rate. (Check out How Interest-only Loans Work for more information.)

According to Bankrate.com, the difference in the monthly payments on a 2/28 interest-only subprime ARM can be dramatic:

	Loan	Rate	Monthly payment
First two years	$200,000	7%	$1,330.60
Third year	$200,000	11%	$1,922.96

As you can see, it's likely when the introductory period runs out that you'll be in store for a much higher monthly payment. While it's possible to refinance after this period, the current leveling of appreciation values in the U.S. housing market has made it difficult to gain much ground. It's also important to remember that every time you refinance, you must pay a new set of closing costs to your lender.

Subprime loans often have a prepayment penalty included in the terms. This means that if you're able to pay the loan off early, you must pay extra fees.

They may also have a balloon payment attached. This is when the remainder of the loan is due after the introductory period in one lump sum. Borrowers generally plan on refinancing at this point, but this isn't always possible. Even if it is, you can end up with much higher rates.

There are other factors aside from your credit score that decide whether or not you fit into the category of subprime. According to MSN Money, your potential loan may be subprime if you have:

Missed any credit payments in the past three years
Declared bankruptcy in the last seven years
Consistently overdrawn your bank account
Defaulted on any credit
Previously been foreclosed on or have repossessions in your history
Consistently been late on your bills or have had utilities shut off

It's also important to remember that your credit is affected by anything you have co-signed with another person. People who get divorced are often surprised to find out that their former spouse has defaulted on loans that ruin your credit score.

In the next section, we'll examine the subprime mortgage crisis and what's being done to fix it.

Subprime Mortgage Crisis

The large number of defaults and foreclosures on subprime mortgages since 2006 has led to what some call a subprime mortgage crisis: 2.2 million subprime loans in recent years have ended or will end in foreclosure at a loss of $164 billion. And it's not over yet. An estimated one in five subprime mortgages will fail in the next two years [source: Federal Reserve].

The blame for the crisis is shared among several factors. Many mortgage brokers steered their clients toward loans they couldn't afford. Previously, when someone wanted a loan, he or she would go directly to the bank. More and more, people are going to mortgage brokers to act as the go-between. The result is an industry that isn't directly accountable when a loan goes bad. Mortgage brokers don't suffer any penalty when a loan they drafted is defaulted, so there isn't much incentive to turn down applicants in this commission-based industry.

The unemployment rate is also a factor in the crisis. Midwestern states hit hard by auto industry layoffs rank among the highest in foreclosures [source: Federal Reserve]. Many people were counting on being able to refinance to make their loan affordable, but slowing appreciation rates in the housing market have made it difficult or impossible. Once the introductory period on the subprime loans ran out, the new payments were more than many could handle.

The borrowers also must bear some responsibility. It's common for someone looking to get into the housing market to overstate his or her income to secure a loan.

Another ugly facet of the subprime crisis is the assertion that many lenders exploited minorities in the rush to get rich. The Home Mortgage Disclosure Act (HMDA) of 1975 made it mandatory for lenders to maintain and disclose data in relation to their loans. In recent years HMDA numbers vary wildly across racial lines. Black and Hispanic borrowers are more likely to have a subprime loan than Caucasians. In fact, in 2006, there was a difference of 36 percent, with 53 percent of blacks having subprime mortgages compared to only 17 percent for Caucasians. In addition, a 2006 study by the Center for Responsible Lending (CRL) found that when credit risk was equal, blacks were still 31 percent to 34 percent more likely to receive a higher rate than Caucasians [source: CRL]. In July 2007, the NAACP filed a lawsuit against 14 leading subprime lenders for practicing "systematic, institutionalized racism in making home mortgage loans." The suit is based in part on the CRL study [source: NAACP].

Neighbor Works
Not all the news is bad in the world of subprime lending. One nonprofit organization called Neighbor Works America is doing something about it. Through its Center for Foreclosure Solutions, the organization has joined forces with mortgage and insurance companies to reach out to borrowers in need. It trains foreclosure counselors to assist borrowers and inform communities of their options.

Neighbor Works took action after learning that a common problem between subprime lenders and their clients is a lack of communication once the borrower fell into financial straits. Often, the borrower is ashamed or afraid to call his or her lender, even though there are actions that could be taken to prevent foreclosure. Lenders often have trouble locating the people in need of advice.

Neighbor Works received more than 100,000 calls so far in 2007 on their hotline. To explore your options, you can call the hotline at 888-995-HOPE, or visit their Web site.

For more information on subprime mortgages, please explore the links on the following page.

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How Subprime Mortgages Work