5 Things That Determine The Interest Rate on a Subprime Mortgage
There are several factors that contribute to the final interest rate offered to you on your mortgage. Here are the main components that contribute to your interest rate.
Loan-to-Value Ratio
This is the amount of money a lender will allow you to borrow relative to the value or sales price of your home, expressed as a percentage. In other words, if your lender will offer you up to an 85% LTV and your home is worth $100,000, that means you can take out a loan for $85,000. The higher the LTV, the higher the risk the lender is taking. For example, if a subprime lender is willing to lend you 100% of your home’s value and you default on your loan, there is no equity left to the lender to recoup. Foreclosures cost banks money and if the property values of homes in your area are declining, the lender may end up with a substantial loss.
Credit Score
If you are in the subprime lending sector, your credit score is often between 500 and 620. The lower the score, the higher the risk to the lender. At an 85% LTV for example, one lender is currently offering an interest rate of 7.3% for borrowers with a 620 credit score and an interest rate of 8.95% for borrowers with a 500 credit score. Make sure you know all three of your credit scores! The majority of lenders will look at the middle of the three scores to determine your credit grade.
Other Factors
Your loan amount, a previous bankruptcy or foreclosure, level of income and asset documentation provided and loan type are all factors in determining your rate. Also, if you pay points down at closing your rate will generally be lower than if you choose to have the origination fees associated with your loan financed in the form of an increased rate.
Adjustable Rate Mortgages (ARMs) and Indices
By far the most popular products in the subprime sector, adjustable rate mortgages are fixed for a certain time period (usually 2, 3 or 5 years) and then adjust according to market conditions.
So how is that rate determined?
Your ARM is tied to an index. There are many indices out there (1-month, 6-month, 12-month LIBOR, COFI, MTA, COSI) and others. An index may be based on any number of things; T-Bills are based on the interest the U.S. government pays on its $8 trillion + foreign debt and LIBOR indices are the averages of the interest rates that major international banks charge each other to borrow U.S. dollars in the London money market. The main point to remember is that your ARM is based on only one of these indices, and the 6-month LIBOR index seems to be the most common index used in the subprime lending market. This index, along with many others, are published daily in the Wall Street Journal and can be easily found online. Your lender has no control over the variation of your index. Here is what they do have control over:
Margin
Every ARM comes with a margin, which is simply the amount added to the index at the time your interest rate is set to adjust. Your final interest rate is equal to the margin + the index. The margin is usually related to the risk of the loan, but not as much so as with your initial interest rate. Lenders tend to set their margins based on the number of late payments you’ve had within the past year or so. For example, if you have been 30 days late on one mortgage payment, your margin may be 6.25, where if you have been late 30 days late twice in the past year, your margin may be 6.45.
So, you are offered a rate of 7.75% on a 2/28 ARM. What happens to your rate then? If the 6-month LIBOR stays the same as it is now (about 5.3%), your lender will add your margin of say, 6.25. Does that mean your rate will immediately increase to 11.55%? Probably not. Partly to avoid defaults, lenders set adjustment caps on their loans. The initial adjustment cap on a subprime mortgage is typically 2% or 3%. Let’s say your cap is 2%. Your rate will then be 9.75% (7.75% initial rate plus 2%). The 11.55% rate is called the fully indexed rate and would increase every 6 months by as much as your periodic rate cap will allow (usually 1% to 1.5%). Finally, the lifetime cap (often 6% or 7%) will let you know exactly how high your rate could escalate. Review your financial goals carefully with your loan officer and make sure your understand all of the features of your mortgage.
