“I hear terrible things about sub-prime lenders. What are they, and how can I avoid them?”

A sub-prime lender is one who lends to borrowers who do not qualify for loans from mainstream lenders. Some are independent, but increasingly they are affiliates of mainstream lenders operating under different names.

Sub-prime lenders seldom, if ever, identify themselves as such. The only clear giveaway is their prices, which are uniformly higher than those quoted by mainstream lenders. You do want to avoid them if you can qualify for mainstream financing, and I’ll indicate how shortly.

The failure to qualify for mainstream financing is due primarily to some combination of four factors: low credit scores; inability to make a large enough down payment; excessively high levels of debt payments relative to income; and inability to document income and assets adequately. None of these deficiencies is likely to disqualify an applicant, but a combination of them will.

Other factors that can enter the equation include purpose of loan and property type. For example, a borrower who is weak on some but not all of the factors indicated above might squeak by if purchasing a single-family home as a primary residence. But the same borrower purchasing a 4-family home as an investment might not make it.

Sub-prime lenders base their rates and fees on the same factors as prime lenders. For example, rates are higher the lower the credit score and the smaller the down payment. However, the entire structure of rates and fees is higher at sub-prime lenders to cover the greater risk and higher costs of sub-prime lending.

A higher percentage of sub-prime than of prime loans go into default. Among loans that don’t default, a higher percentage prepay early. Sub-prime lending costs are also higher because more applications are rejected and marketing costs are higher.

The development of the sub-prime market has made mortgages (and home ownership) available to a segment of the population that otherwise would have been shut out of the market. That’s the good news. The bad news is that some borrowers who are eligible for loans from mainstream lenders end up in the sub-prime market. They are prime borrowers but they pay sub-prime prices.

This happens partly because of the difficulties some borrowers can have in determining whether they qualify in the mainstream market. Underwriting requirements can differ from one mainstream lender to another, so it is quite possible that a borrower with problems, who is not eligible at one lender, will be eligible at another.

Qualifying a borrower with problems, furthermore, may require a great deal of time, effort and skill by the loan officer or mortgage broker. Some will take the easy way, when borrowers permit it, and classify them as sub-prime.

However, the main reason some prime borrowers end up paying sub-prime prices is that they are solicited by sub-prime lenders and go along with the deal pitched to them without ever contacting a mainstream lender. Very few sub-prime loan officers will give up a commission by referring a qualified applicant to a mainstream lender. The deal will very likely go down at sub-prime prices, therefore, regardless of how qualified the borrower may be.

Sub-prime lenders market aggressively to homeowners who already have mortgages. A major pitch is the cash that borrowers can take out of their properties through a cash-out refinance. They target groups and areas that promise to have many sub-prime borrowers–lower-income black neighborhoods, for example. Many occupants of such neighborhoods will be sub-prime, but those who aren’t and who go along with the soliciting firm will pay sub-prime prices.

Here are some guidelines to prevent that from happening to you:

  • Never respond favorably to a solicitation without first checking other options. If you deal with only one loan provider, your prospects are better if you make your selection by throwing a dart at the yellow pages than by accepting a solicitation.

  • Check your eligibility for mainstream financing with mainstream lenders. The easiest way to do that is online. Some sites that I like for this purpose are Eloan.com, homemortgagecenter.com, countrywide.com, mortgage.etrade.com, mortgage.com and Indymac.com.

  • If you can’t qualify with any of them, your best bet is an Upfront Mortgage Broker (they are listed on my Web site). They may charge sub-prime applicants a little more because they require more time. You will know what they charge, however, and you will know that you are getting the wholesale price posted by the lender, which means you won’t be exploited.

The writer is Professor of Finance Emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at www.mtgprofessor.com.

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