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The Basics of Subprime Mortgages
When looking for a home loan, whether you are refinancing, buying a new home or getting a home equity loan. It will be more difficult if you have credit problems. After a bankruptcy, repo or foreclosure, getting approved for a home loan can seem almost impossible. However, there are more programs available for subprime borrowers today than ever before.
Adverse Credit History - Low Income - Debt-To-Income ratios - Simply put, a sub-prime or non-prime borrower is a borrower who does not meet the requirements of a mainstream lender. This could be for a number of reasons: adverse credit history, income documentation issues, higher debt-to-income ratios than normal, a previous bankruptcy, foreclosure, or even past enrollment in a consumer credit counseling program. Rates and fees on these loans are generally higher for borrowers with adverse credit, as they are considered to be a higher risk than the loans offered to borrowers without any past credit issues. For the most part, if your credit score is below 620, you will be offered a sub-prime lender or steered towards a lender or broker that specializes in these types of loans.
What Do Sub-Prime Lenders Look For - Sub-prime lenders look at borrowers differently than mainstream lenders in several key areas. Almost all sub-prime lenders are going to look very carefully at your rental or mortgage history from the previous twelve to twenty-four months. They generally grade you according to this housing history and will assign you a letter grade: e.g., A+, A, A-, B, C, D. AAA, AA or A+ borrowers (the letter assigned depends on each lenders grading system) usually means that you have not been late once on your rental or mortgage payment in the past twelve or twenty-four months. For renters, make sure when you apply that you can provide cancelled rent checks if your landlord is not affiliated with a rental management company. This can be a deal breaker with sub-prime lenders. However, there are an increasing number of non-prime lenders that will accept whats called a private VOR. That means they will fax or mail a standard form called a Verification Of Rent to your landlord asking what your rental history has been. They are mainly looking for how long you’ve rented and if you’ve had any payments that have been more than thirty days late. Most conforming lenders are less strict with this issue, because you would in all likelihood already have very good credit and low enough debt ratios to qualify for their programs.
Your FICO Credit Score - Most sub-prime lenders are also credit score driven, meaning your interest rate is going to be higher with a 540 credit score than with a 560 credit score. There are only a handful of lenders out there that will give you a mortgage if your credit score is below 500, which is considered very poor credit. If your score is below 500, your best bet is to find someone that is willing to be the main borrower (and live with you!) and have the lender accept a co-borrower with a credit score below 500, as some will not. The other option if your score is below 500 is to not be on the loan, but be listed on the title.
Typical Sub-Prime Mortgage Interest Rates - Sub-prime loans are generally priced 1% to 2% above current market rates because they are considered higher risk loans. The rate you quote will generally be for a 2/28 ARM (Adjustable Rate Mortgage) unless you specify a 30-year fixed quote, which recently has been running from 0.5% to 1% higher than most 2/28 ARMs. When a broker or lender gives you a rate quote, make sure you know all of the terms of the mortgage and the type of loan youre being quoted. For example if you are quoted 7.5% with no points.
Bad Credit Usually = PrePayment Penalties - Find out how long the pre-payment penalty is and whether it is hard or soft. Many borrowers dont realize that if you get a mortgage with a two or three year hard pre-payment penalty and decide to sell before your pre-pay term is up, you will most likely have to pay several thousand dollars to the lender! However, if your pre-payment penalty is soft, you will only have to pay a fee if you decide to refinance that first mortgage. Home equity lines of credit (or HELOCs) are most often used as second mortgages, and many lenders do not charge you as much if you want to pay off your line of credit early.
Sub-Prime ARM Loans - Also ask what the caps are on your ARM (Adjustable Rate Mortgage). There are three numbers used when describing rate caps. The first number tells you the maximum amount (in percentage points) your rate in change initially. The second number tells you what the periodic adjustments are (the maximum percent your rate can change at each adjustment interval) and the last number is the ceiling rate on your loan. The final number is important because it will tell you what the maximum interest rate your loan can adjust to. For example, a 2/28 ARM with 3/1.5/7 caps means that your rate is fixed for the first two years, can adjust 3% after those first two years, can adjust 1.5% a each interval (generally 6 months or a year) and cannot adjust more than 7% during the life of the loan. The same rate on a 2/28 ARM with 2/2/6 caps is probably a safer bet. If this is all confusing to you, as it is to most people, don’t be afraid to ask your broker or lender to explain it until you feel confident you understand everything. Thats their job.
Consider an ARM Loan To Save Money & Rebuild Credit - Don’t reflexively gravitate to a 30 year fixed rate loan; if you’re getting youre first mortgage and you have a less than perfect credit history, paying your mortgage on time for two years can usually increase your credit score enough to refinance with an A-paper lender when your mortgage is set to adjust. If you see a 2/28, 3/27, or 5/25 ARM as a time period to carefully manage your credit, you will almost always save money in interest with the lower rate the ARM offers. If you notice, the 2/28, 3/27 and 5/25 all add up to 30. This is not a coincidence. The second number almost always refers to the remaining time left on your mortgage. Also keep in mind that the average mortgage is only held for 5 to 7 years. There are a very small percentage of borrowers who keep their original mortgage for a full 30 years. Job and income changes, relocations, and market conditions vary so often that most people move or refinance within 5 to 7 years and studies show that first time homebuyers keep their original mortgage for even less time. (Theres a reason they’re called starter homes)
Interest Rates & Paying Points - Unless you envision staying in your home for more than 5 to 7 years, its generally a good idea to keep the number of points you pay to a minimum. A point is equal to 1% of your loan amount. You can pay any number or fraction of points (for example, 2.25 points) depending on several variables. Paying discount points is done to lower the rate on your mortgage. Therefore, if you take out a $200,000 loan and only plan on keeping your loan for two or three years, dont pay two points ($4,000) to keep your rate low. There is always cost/benefit analysis that your broker or lender can help you with depending on your specific plans. If you’re pretty sure you will be staying in your home for more than a few years, can afford it and think that the housing market and interest rates are pretty low (historically, they are low now), by all means, pay points on a 30-year fixed rate. Although rates bottomed out around late 2003 with the prime rate at only 4% and a 30-year fixed rate at 5.23%, rates are still relatively low now. Keep in mind that in October of 1981, a 30-year fixed rate mortgage was 18.45%! Its illegal in most states now to charge that rate on a mortgage.
Your Credit History - Dont forget to get a copy of your credit report either from your lender or from a credit agency directly (Experian, Transunion or Equifax) or at www.myFICO.com. Working with a mortgage broker is especially a good idea for non-prime borrowers, as almost all brokers should have a good deal of experience closing more complex loans. Review your credit report carefully with your broker because there’s a good chance there are errors in it. Some studies claim that up to 75% of all credit reports contain at least one error and if you are in the sub-prime market, that could make the difference between an approval and a rejection. You can easily dispute any errors on your credit report online, right on the credit reporting agency’s websites.
Free Credit Report - Yearly, Annual Report - For an absolutely free copy of your credit report, you can find you annual credit report available at www.annualcreditreport.com. You are entitled to 1 free credit report check per year and that is the place to get it.
100% Financing- No Down Payment - Zero Down Programs - Having poor credit will make it more difficult to qualify for programs that involve no down payment or 100% financing. However, it’s not impossible to qualify. Work on increasing your credit score and strengthening your debt-to-income ratio.
Stated Income and No-Doc or No Documentation Mortgage Loans - Qualifying for no-doc or stated income loans will be more difficult when you have bad credit. However, if you are doing a stated income or no doc loan, strengthen the other factors in your application, like consider putting down a down payment or work on increasing your credit score.
Don’t believe the notion that having bad credit automatically disqualifies you from being a home owner–it just may take a little more time to find the loan that is right for you.
