The main difference between prime and sub-prime mortgages lies in the risk profile of the borrower; sub-prime mortgages are offered to higher-risk borrowers. Specifically, lenders differentiate among mortgage applicants by using loan risk grades based on their past mortgage or rent payment behaviors, previous bankruptcy filings, debt-to-income (DTI) ratios, and the level of documentation provided by the applicants to verify income. Next, lenders determine the price of a mortgage in a given risk grade based on the borrower’s credit risk score, e.g., the Fair, Isaac, and Company (FICO) score, and the size of the down payment.
Lenders usually charge the prevailing prime mortgage rates to borrowers with lower credit risks as reflected by their finance home improvements. The mortgage business landscape transformed as technology made it possible to automate credit checking and underwriting procedures, thereby significantly reducing the time and expense involved in these processes. Furthermore, the use of credit scoring systems made it possible to speed up the evaluation of mortgage applicants’ risk profiles and increase the volume of applications processed.
On June 29th Federal Financial Regulators in a long-awaited policy statement on loans urged for banks, credit unions and their mortgage subsidiaries to verify income, assets and employment on all loans to borrowers with imperfect credit histories except in special cases where borrowers could demonstrate substantial financial reserves.
The policy course of action, which took effect without delay nationwide, also instructed lenders to underwrite adjustable-rate sub-prime mortgage applicants at the “fully indexed” interest rate, not at a deeply discounted teaser rate. During the boom years, many lenders had lured credit-impaired home buyers into adjustable-rate mortgages featuring discounted fixed payments for the first two or three years.
The consumer will in general welcome these new guidelines, but I believe they won’t make a dent in the continuing sub-prime crisis or put a stop to lenders from issuing new mortgages with deadly features. Adoption of the guidelines state by state is going to take months, and in the meantime, a lot of consumers will still be getting loans with the same old harmful features.
In the meantime, I advise home buyers to adopt their own smart mortgage guidelines:
- If you’ve had credit problems and your current income just barely qualifies you to buy the house and you are pre-approved for a short-term discounted-rate loan, resist the temptation even if a loan officer or broker is pushing you to sign.
- Insist on an escrow account if you have marginal credit. It means higher monthly payments, but it guarantees that you won’t end up owing thousands in property taxes that you don’t have the cash to pay.
- If your loan officer says that agreeing to large prepayment penalties is the only way you’ll ever get a mortgage, shop around more. In a competitive marketplace, you may discover that you’re not viewed as sub-prime by every lender, and you did not need to be hog-tied by any prepayment penalties.
