Editor’s note: Steven Krystofiak offers an insider’s take on what’s been unfolding in the subprime mortgage industry. But he is no industry apologist. Stay tuned for a series of articles from Krystofiak on Inman News in coming weeks.
What constitutes a subprime loan? There is confusion in the industry infatuated with using a word without a proper and uniform definition. Is the decision of whether or not a loan is subprime based on income? How about the type of loan you get? Is it your credit score? Will you be forced to have a prepayment penalty if you get a subprime loan? Is it a term that Wall Street traders use for bond ratings secured by mortgages? Is it the amount of equity that one has in his or her property?
I will explore the above questions from an insider’s point of view, and hopefully guide you where the frustration lies within this subject.
Outsiders looking into the mortgage industry often believe that having a low income means you are forced to get a subprime loan, which in turn leads to a higher interest rate. But nothing can be further from the truth. Contrary to that belief, income has absolutely nothing to do with being offered only a subprime loan. In fact, many banks will give a lower and more competitive below-market interest rate to low-income individuals.
Banks actually love working with low-income families because when funding mortgages to these families the bank obtains a highly sought-after CRA credit. Regulators are required to consider these credits during the application process for mergers and acquisitions.
On the other side of the curve a person who makes $1 million a year can certainly be a subprime candidate. That person may not pay his bills on time, have too much debt, or could have a bankruptcy in his immediate past. All these factors are considered red flags and usually tall tale signs of a suitable candidate for a subprime loan.
In recent weeks and months there has been a lot of talk on Wall Street about securitized and traded subprime mortgages that would be classified as a low class of risky bonds rated as BBB-. So that must be it — I have found the definition.
But not so fast.
Upon further research I have found some subprime mortgages being traded as nonrisky, “A”-rated-type bonds. (See this Reuters article.) My research must go on.
A consumer group that is viewed as the main watchdog group for the subprime industry tells me that a subprime loan is defined as a loan that has an interest rate three percentage points above the yield on equally termed treasury security, such as a 5-year or 30-year T-Bill. This in an unconfirmed definition that the group says comes from a widely unknown Home Ownership and Equity Protection Act known as HOEPA. If this was uniformly true then there are many subprime lenders that offer interest rates below that bench mark. This confusing definition might be used during congressional hearings, but it means little when a consumer is negotiating with a lender for a home loan.
What about the risky mortgages that have caught on too as being mainstream in many areas? I am talking about interest-only loans, no-money-down loans, short-term fixed-interest-rate loans or the extremely risky option-ARM loans. These loans upon themselves do not justify classifying a borrower as a subprime. There are many prime customers and exclusively prime lenders that make these loans.
What about credit score? This is probably the best and most widely accepted variable that would determine if someone were to be a subprime candidate. But there are no uniform guidelines, numbers or benchmarks, just many shades of grey. To fill in the shades of grey between subprime and prime loans, a newly popular group of Alt-A loans has been established. They too have no definition, but serve a purpose for borrowers that are not found on the ends of the spectrum like subprime and prime loans.
A borrower with a credit score below 680, 660, 620 or 600 all may or may not be considered subprime. Subprime lenders do take on clients with high credit scores who might have other mitigating factors that would prevent them from receiving a loan from a traditionally prime lending bank. With that said, I do see one’s credit score showing the most promise forming a definition of subprime, but important to note is that the smell test is not judged solely on this number.
There is a menu of options and variables that everyone has in their financial past. Banks and lenders realize that, and rightfully so do not overly judge one negative if a candidate has other redeeming qualities. Subprime clients usually have numerous negative quirks or mistakes from their past that come to light during the exploration and underwriting of their loan application.
So what is a subprime loan? It is confusing and frustrating. I will be the first to admit that I do not know for certain. For my official answer I would like to quote Supreme Court Justice Stewart when he gave his opinion on what is hard-core pornography: “I know it when I see it.”
Steven Krystofiak is a mortgage broker based in California. He is president of the Mortgage Broker Association for Responsible Lending, an advocacy group.