Are All Subprime Mortgages Predatory Loans?

Lighthouse on a foggy day Subprime mortgages are typically loans with tough terms and high rates. So does this mean all subprime loans are examples of predatory financing?

In the usual case the answer is no. Subprime mortgages are a form of financing which should be used only for borrowers with woeful credit, individuals with a history of failing to repay bills. Such borrowers — by definition — represent more risk to lenders and for that reason alone should face higher interest rates.

Unfortunately, with subprime mortgages many borrowers have failed to shop around and thus have been saddled with interest rates and tough loan terms which do not reflect their financial status. For example, the Wall Street Journal has reported that 55 percent of all subprime borrowers in 2005 actually qualified for FHA, VA and conventional financing. The Journal also reported that 61 percent of all 2006 subprime borrowers also paid more than they should for real estate financing, that they qualified for lower-cost FHA, VA and conventional loans. (See: Subprime Debacle Traps Even Very Credit-Worthy, December 3, 2007).

But if higher rates and subprime mortgages do not define a predatory loan then what does?

Subprime Mortgages Defined

Miller’s definition of a predatory loan is this: First, a loan which does not fully reflect the borrower’s credit history; that is, a mortgage where the borrower pays materially more than he or she should for financing. Second, a loan which is engineered to fail, financing offered by predatory lenders in the loan to own business. Third, a loan or lending practice which by any reasonable standard should be illegal under federal and state laws. Importantly, predatory lending is NOT a crime under federal law.

Here are several examples of predatory loans:

Equity stripping

In this case the lender finances a property with an excessive number of points. In one recent case a borrower paid 15 point to obtain a mortgage. Also called “fee packing.” Note that under Wall Street Reform lenders may only charge points and fees equal to not more than 3 percent of the loan amount for qualified mortgages with an initial balance of $100,000 or more.

Loan flipping

In this situation a property is repeatedly refinanced. The lender tells the borrowers they can save big money, say an interest rate which is lower by 1/8th, but each time the property is refinanced the lender gets thousands of dollars in points and fees. The lender will go back to the borrower every four to six weeks to refinance as long as the borrower will go along with such deals. With loan flipping the borrower does not obtain a material tangible benefit each time the property is refinanced.

Secret Balloon Note Features

Balloon notes are not defined as a qualified mortgage under Dodd-Frank, however one needs to be careful with balloon notes because they can be — or not be — a legitimate form of financing.

A balloon note works like this: a $100,000 mortgage at 4.5 percent interest with monthly payments based on a $30-year schedule and a five-year term. The result? Monthly payments for principal and interest of $507 for five years — and then the loan is over and the borrower must pay $91,158.

I have had balloon loans and they were not predatory because (1) I knew I had a balloon note, (2) I knew how much was due and (3) I knew when it was due. However, the very same loans would be predatory if the borrower did not know these three facts.

Interest increases in the event of default

With these loans the borrower gets financing at 4.5%. Six months later a payment is 20 minutes late and thus in default. The interest rate instantly rises to 7 percent. If the borrower is late again the interest rate rises further.

Interest rate increases upon default at a level not commensurate with risk mitigation

Direct payments to contractors

With this arrangement a borrower hires a contract to make repairs. Conveniently, the contractors gets the repairs financed through a “lender.” The lender pays a contractor directly. The loans are┬áthen sold into the secondary market. The borrower now owes the debt but has no leverage to assure that repairs are completed, done correctly, or meet expected quality standards because the contractor has already been paid.

Is there an alternative to subprime mortgages and predatory loans? Yes. Don’t borrow. Instead pay down bills, make a budget, stick to the budget and bulk up savings. Your credit profile will evolve and you will be able to finance with better loans and lower costs.

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