Subprime Homeowners in Denver Need to know the Details

Three Characteristics of a Subprime Mortgage

The term “subprime mortgage” refers to a category of mortgage that carries a greater than average risk.  Although there are many risk factors that contribute to this, the single greatest factor is a poor credit rating.  Subprime mortgages had their place in the market for many years, but over the years the lending practices became more and more aggressive.  This has led to the collapse of many subprime lenders.  According to a website tracking subprime lenders demise called mortgageimplode.com between the Fall 2006 and Spring 2007, 44 national mortgage companies have closed, filed for bankruptcy, or have been sold to larger financial firms for restructuring.  The lenders on this list have conducted very risky business.   Loose guidelines and aggressive loan programs have spelled trouble for the industry.  Here are three questionable characteristics of a subprime mortgage. High margins on adjustable rate mortgages (ARM’s), pre-payment penalties, and interest-only loans.

First, subprime adjustable rate mortgages.  All adjustable rate mortgages use an
index and a margin to determine the final interest rate.  This is determined by adding the index to the margin.  It’s just that simple.  The index fluctuates with the market, and the margin is fixed.  The index for most subprime adjustable rate loans is the 6 month LIBOR.  The important part here is that once the interest rate starts adjusting it may do so every six months.  The margin on a subprime loan is very high.  When the teaser period of the loan is up, usually after two years, the payment on the loan is going to increase.  It is designed that way.  When the payments increase the borrower is not prepared.  They want help to get out of a loan which they can no longer afford.

Second, pre-payment penalties create a situation in which the borrower is trapped.  They have no option to get out of a subprime loan without incurring a tremendous expense. Thousands of dollars are added to the balance of the loan to pay off early.  To make matters worse, some pre-payment penalty terms are three years and ARM teaser periods are only two years.

Third, subprime interest-only loans create a situation where the homeowner becomes the equivalent of a renter. The interest paid on the loan does not decrease the balance of the loan.  The borrower can put off paying the principle today, but will have to pay it someday.  Someday is in five or ten years. Then the loan is changed to a fully amortized principle and interest loan.  The new payments are re-calculated based upon the original balance, which is still the same, and a new much shorter term. A thirty year mortgage with ten years interest-only leaves twenty years to pay back the entire balance.  Once again the payments will increase. Once again the borrower will want out of a loan they can no longer afford.  

These three characteristics have contributed to an increase in default on subprime loans leading to foreclosure.  Loose guidelines and other factors have also contributed to the turmoil.  Be aware of the characteristics of your next mortgage loan.  The details matter.

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