Subprime mortgages are back, but is that a good thing?

subprime mortgagesSubprime loans seen today are very different from their cousins from 2000 through 2008. Under Dodd-Frank, lenders must show that borrowers have the ability to repay their loans, an absolutely obvious standard but one which was too often abandoned during the go-go mortgage era, a time infested with no-doc loan applications, subprime mortgages with prepayment penalties and toxic loan products.

To give you an idea of just how loose and idiotic lending standards were in the run-up to the mortgage meltdown one need only look at the Mortgage Credit Availability Index (MCAI). According to the Mortgage Bankers Association the MCAI reached 113.5 in February, meaning loan standards are looser than in March 2012, the base month. In comparison, says the MBA, “if the MCAI had been tracked in 2007, it would have been at a level of roughly 800, indicating the credit was much more available at that time.”

Subprime Mortgages

To understand what this means, imagine that instead of cooking a chicken at 300 degrees it was instead baked at 2,400 degrees. Things might be eight times hotter, but like a lot of subprime mortgages and alternative loan products from 2007 you would wind up with something hideous.

So what makes subprime mortgages more attractive to lenders today?

First, many subprime loans are not qualified mortgages, which means lenders can get bigger fees up front and thus more profits.

Second, we have re-defined the subprime space. It used to be that a credit score below 580 or so put you in subprime territory. Now the bar has been raised so that scores below 600, 620 and 640 — depending on the lender — are considered subprime. The effect of this change is to create less risk for lenders as well as higher costs for marginal borrowers.

Third, seriously impaired borrowers, those with credit below 580 are out. On one hand such borrowers represent too much risk, on the other it’s not unreasonable for lenders to say that borrowers should have a certain credit standing before getting a loan. Think of it this way, you would not make a loan to someone without an acceptable level of assurance that the money would be paid back.

Subprime Mortgages and The FHA Exception

The exception is FHA financing. The FHA offers loans to borrowers with credit scores between 500 and 580 as long as they put down 10 percent instead of the usual 3.5 percent. Such loans are out there today. right now, but the odds are overwhelming that few lenders are offering such financing — despite the fact that FHA insurance offers lenders 100 protection against loss.

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