ubprime is used interchangeably throughout this page, and whatever the name, the concept is the same. That concept is to provide lending programs for those borrowers whose financial picture doesn't fit into or meet the underwriting requirements of traditional government-backed or Conventional loans. This could be for a variety of reasons. If you believe that Subprime Lending is for those who may have past or current credit problems, you would be partially correct. It is estimated that over 80% of all borrowers have some sort of derogatory items on their credit report. Yet, it is more than just that. If you currently have a second mortgage, you also have a Non-Conforming loan (and whether you call it a home improvement, debt consolidation, or home equity loan, if it's in second position behind your first mortgage, it's a second mortgage). With that in mind, we'll discuss second mortgages as a lead-in to other types of Non-Conforming loans, or you can skip straight to Subprime/B-C-D/Non-Conforming Lending.
Second mortgages, in much the same way as B-C-D loans, do not conform to traditional first mortgage underwriting guidelines. When lenders underwrite loans, they package them into million-dollar portfolios and sell them to investors in the secondary mortgage market. Loans are bought and sold all the time (if you're a homeowner, you probably have at one time or another received a letter telling you that your loan had been sold, giving you the new address to where you should send your loan payment). This is how lenders get their money returned so they can make more mortgage loans. Lenders can't sell their loans on the secondary market if they don't meet the guidelines dictated by that market, so if a borrower's needs can't be met by a loan program that fits the underwriting requirements of the secondary market, another way must be found to meet those needs. This is the market niche for Non-Conforming loans.
For example, if you had purchased a new home with Conventional financing, you would have had (among other things) to put at least 20% down so that your loan didn't exceed 80% of the home's value. Let's say that after you'd lived in the home for several years you wanted to make some improvements. You could refinance with a new first mortgage to tap into your equity, but there might be several reasons for that not to be your best option.
First, the maximum cash-out Loan-to-Value you would be allowed under Fannie Mae guidelines (assuming you wanted to roll the closing costs of a refinance into the new loan, itself) would be 75%, as funds for any purpose other than paying off existing mortgage loans are considered cash-out funds. That would mean that after paying the costs associated with refinancing into a new first mortgage in order to pay off your existing loan(s), the amount of equity remaining to fund your home improvement project would be limited to 75% of your home's value, minus the amount of your new first mortgage. That wouldn't help you if you needed 85% Loan-to-Value financing to provide enough money to fund your project.
Second, maybe current interest rates have increased considerably over your loan rate, and you'd like to keep the loan (and the rate) you already have.
Third, it's possible that even though you have a stable, well-paying job with good prospects of remaining so, you might have acquired enough consumer debt since purchasing your home to keep you from meeting the required Debt-to-Income ratios for a new first mortgage, regardless of your available equity.
A good option in this case would be to tap into your equity with a second mortgage. The same would hold true for consolidating consumer debt.
Second mortgage rates are higher than first mortgage rates because the lender's risk is higher. This is why a borrower who wants a 100% home equity loan has to have spotless credit. Even though the borrower may have an excellent credit report, the lender in second position is taking on a tremendous risk. If the borrower were to default on the loan and the lender(s) had to foreclose, the first position lien holder gets paid first, then the second, and so on, assuming there are any funds left after the first lien holder is paid. To balance or manage this risk, lenders charge higher rates for their subordinate lien position.
Risk management plays a role in all lending decisions, and the Subprime/B-C-D/Non-Conforming market was created with this in mind, to help those borrowers whose credit or income would preclude them from obtaining financing through traditional channels.
As second mortgages present a higher lender risk than first mortgages, so too, do loans to those whose credit is bruised, or those with higher Debt-to-Income ratios. Derogatory credit items can include such things as late payments, collections, liens, judgments, and charged off accounts. Also listed on the credit report is a number, a numerical score, that decreases as the number of derogatory items and factors in the credit report increases. There are different scoring systems, including ones from BEACON, FICO, and EMPIRICA, but they serve the same function, that is, to reduce the credit report to a numerical score. Some lenders (fairly or unfairly) consider only this score in their lending decisions. Other lenders will use the credit score as one of the factors in making a lending decision, while looking at the overall content of the credit report.
Other factors, such as carrying balances on your open credit accounts that are considered too high (e.g., having your credit cards maxed out, or nearly so), or having too many open credit accounts, even with low balances (still giving you the opportunity to run up significant debt), can lower your credit score. B-C-D lenders use these credit scores along with a credit-scoring matrix to rate or grade the borrower according to the amount of derogatory items on the credit report (for information on how derogatory items are reported, see the discussion of credit on The Three C's of Financing). The more derogatory the credit report, the higher the rate and (usually) the lower the allowed Loan-to-Value, though Debt-to-Income ratios can be quite lenient (as high as 50%, sometimes even higher).
Typical B-C-D lending guidelines will allow for some late payments on the credit report, including late mortgage payments. There are even programs (given enough equity in one's home) that can pull a homeowner out of foreclosure, or pay off a Chapter 13 bankruptcy. However, B-C-D lending rates are higher not only because of the increased risk. There is an additional reason.
While lenders allow much more leniency in underwriting guidelines with B-C-D lending (and charge, accordingly), they know that most of these loans will be paid off before they ever reach their full term. That's because B-C-D loans are a "BAND-AID" approach to financing, to help a borrower accomplish immediate goals, right now, with an eye toward getting the credit report cleaned up in order to qualify for the best possible rates in the future. Since one of the goals of your mortgage broker is to help you map out a plan to accomplish just that, in as timely a manner as possible, and lenders know this, they need to make more of their profit on the front end, as most derogatory credit can be cleaned up in a couple of years. Therefore, use B-C-D financing today, if need be, to help while you get control of your financial situation, and as soon as your credit and circumstances will allow, refinance to get the best going market rates.
Some of the larger banks, seeing the success of independent mortgage brokerages, have Johnny-come-lately jumped onto the Subprime Lending bandwagon. However, they still "think" like banks, and many of their programs just don't have the flexibility and variety that an independent brokerage such as Austin Home Loan, can provide. Besides providing a full range of traditional financing products, we specialize in helping the more difficult-to-qualify clients obtain the financing they need (whether for a purchase or refinance), and to provide the knowledge and information necessary to help them get back on track with their credit, so they can qualify for the best possible rates in the future.
If you're in the market for real estate financing, especially if you have past or current credit problems, give us a call to let us show you what we can do for you.