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Subprime lending is a financial term that was popularized by the media during the “credit crunch” of 2007 and involves financial institutions lending in ways which do not meet “prime” standards to an extent which puts the loans into the riskiest category of consumer loans typically sold in the secondary market. These standards refer to the size of the loan, “traditional” or “nontraditional” structure of the loan, borrower credit rating, ratio of borrower debt to income or assets, ratio of loan to value or collateral. Subprime borrowers show data on their credit reports associated with higher default rates, including limited debt experience, excessive debt, a history of missed payments, failures to pay debts, and recorded bankruptcies.The Wall Street Journal reported in 2006 that 61 percent of all borrowers receiving subprime mortgages had credit scores high enough to qualify for prime conventional loans.

A borrower’s FICO score and loan-to-value ratio determine the type of loan a borrower will qualify for and, typically, low FICOs, coupled with high ratios such as 100% financing, result in subprime loans.

• Subprime loans carry higher interest rates than do conventional loans for higher-rated, A-paper borrowers.
• Certain types of subprime loans such as “no documentation” or “stated income” are funded at even higher interest rates, sometimes several points above traditional loans.
• Most are adjustable-rate mortgages.

FICO Score Qualifications for a Subprime Mortgage Loan

Until early 2007, lenders made subprime loans to borrowers who had FICO scores of less than 620. But those ratios are rising in the heat of the subprime market shake-out. Borrowers who once qualified with a FICO of 620 have watched the FICO requirements move to 640 and up. Those applying for 100% financing could once qualify with a FICO of 580, but that number has changed to 620, coupled with almost double-digit interest rate pricing. Today, except for VA, most lenders will not lend at all on 100% financing.

• Major institutional lenders like to see FICO scores above 700, and those borrowers receive the lowest interest rates and terms.
• Borrowers whose FICOs fall between 600 and 700 receive less favorable terms.
• Borrowers with FICOs below 600 are finding it difficult to obtain financing at any interest rate.

Tip: FHA loans do not require a FICO score and may be an option for borrowers hoping to refinance.

Subprime Mortgage Loan Features

The problem with subprime loans doesn’t lie solely with subprime lenders. It’s the product. Popular subprime loans were often 2/28 adjustable-rate mortgages or Option ARMs.

• A 2/28 works by qualifying the borrower at a fixed-rate for two years.
• Beginning with the third year, the rate changes and fluctuates over the remaining 28 years.
• Typically, rates can move 2 percentage points beginning in the third year, and adjust every six months.
• Common cap rates are 6 points over the initial rate, which means a loan taken out at 5% can reach 11%.
• Many 2/28 loans contain a prepayment penalty, adding insult to injury for those who want to refinance.

Reviewed and collected by Sandy Hutchens.

Lets think, says Sandy Hutchens, you’ve weighed your options, and now you want to buy a home. Purchasing a home is one of the biggest investments you’ll ever make. So before you make an offer, make sure you’re ready to take on all the financial and emotional responsibilities that come with owning a home of your own.  To help you make an informed decision, Canada Mortgage and Housing Corporation (CMHC) suggests you ask yourself the following questions before you begin your search for the perfect home:

• Are you financially ready to buy a house? To avoid any unpleasant surprises down the road, take the time now to calculate your net worth, current household budget and any monthly debt payments you already make. This information can help you evaluate your current financial situation, decide how much house you can afford and find out the maximum home price you should be considering. As a general rule, your monthly housing costs (including mortgage principal and interest, taxes and heating) shouldn’t add up to more than 32 per cent of your gross household monthly income. In addition, your entire monthly debt load shouldn’t be more than 40 per cent of your monthly income.
• How much will your home actually cost? Once you’ve figured out the price range you can afford, you still need to take into account all the other costs associated with homeownership. These include up-front costs such as mortgage loan insurance premiums, appraisal and home inspection fees, legal fees, moving expenses and a down payment, as well as such ongoing costs as maintenance and repair expenses, service fees, emergency savings and condo or strata fees.
• What kind of mortgage is right for you? Depending on the size of your down payment, you may have either a conventional or high-ratio mortgage. You will also need to choose the term and amortization period for your mortgage, work out a payment schedule, decide whether you would prefer a closed or open mortgage, and choose between a fixed, variable or adjustable interest rate. To make all of these decisions easier, it can often be a good idea to select a lender and get pre-approved for a mortgage before you begin looking for the home of your dreams.

For more information on buying a home call CMHC at 1-800-668-2642. For more than 60 years, notes Sandy Hutchens, Canada Mortgage and Housing Corporation (CMHC) has been Canada’s national housing agency and a source of objective, reliable housing expertise. This CMHC report was reviewed by Sandy Hutchens.