Mortgages for those with less than perfect credit

The mortgage rate that you pay depends, among other factors, upon your credit score. There are three major credit scoring agencies in the US; the Fair Isaac Corporation (www.myfico.com) compiles these scores and allows consumers to view and track their scores over time.

Credit scores range from 300 to 850; the higher your score, the lower the interest rate you will pay on your mortgage. The credit score depends on the payment history (how many times in the past you have missed payments), the amount of debt you owe, the length of your credit history, the amount of credit you have applied for recently and the types of credit that you have used. The median FICO score in the US is 723. As of April 2008, a borrower with a credit score of 760-850 would pay 5.5% for a 30-year fixed rate mortgage, 700-760 5.7%, 660-700 6.0%, 620-660 6.8% and 560-620 9.2%. Below 620 is considered subprime.

People with poor credit histories traditionally had a difficult time obtaining mortgages. Many years ago, when lenders were stricter, home buyers needed to make a 20% down payment, which was probably a tighter requirement than the credit rating. Even borrowers with good credit had difficulty saving such a large amount and could not get financing. With the financial innovation in recent years there were many new ways to borrow.

One innovation is “piggyback” mortgages. The borrower takes out two loans, one normal mortgage for 80% of the value of the house, and a second, riskier mortgage for an additional percentage. This second mortgage tended to be at a higher rate and a shorter maturity than the normal mortgage, but it essentially allowed the homebuyer to borrow some or all of the down payment.

Once borrowers did not need to have a significant amount of savings to buy a home it was only a matter of time until loans were made to those with less than perfect credit. With the official government policy of increasing homeownership rates there was pressure on lenders not to refuse mortgages to borrowers with imperfect credit; numerous suits were brought against banks for the crime of “redlining” (see here for a settlement where a bank was obligated to offer to make mortgages at “the prevailing interest rate to borrowers who would not otherwise qualify for that rate”). With a rising housing market and low global yields on funds after the recession of 2001, the stage was set for the subprime crisis.

Given the high interest rates assigned by the market to subprime borrowers (roughly 9% at a time when borrowers with good credit paid 6%) the great innovation of recent years was creating adjustable rate mortgages (ARMs) that would allow subprime borrowers to pay low rates for a few years and purchase a larger house than they would otherwise be able to afford (see here for a guide for consumers to adjustable rate mortgages; the part relevant to subprime mortgages is at the end where they discuss hybrid ARMs).

The typical subprime loan is a 2/28 or 3/27 hybrid adjustable rate mortgage (see here for a brief description). This loan has a low rate for the first two or three years and a higher rate for the remaining years. The advantage for the borrower is that they can buy a bigger (more expensive) house right away, pay the low rate for a few years and then refinance to a lower rate. The key to the deal is that if a subprime borrower can pay a mortgage for two or three years his credit will improve and he will then be able to refinance the house at a better interest rate.

Some lenders added prepayment penalties to the deal, meaning that if the borrower repaid the mortgage (refinancing the loan) in the first five years the borrower would have to pay an additional fee. Why did borrowers accept such terms?  Some argue that the prepayment penalties were not obvious to borrowers.  My own experience with several mortgage closings is that there are many documents to be signed at a closing, and it is quite possible that unscrupulous lenders could conceal such terms from borrowers who were not represented by good attorneys.  Regulations to compel lenders to make these terms more obvious have been implemented in the recent past.

But during the 2004-2006 housing bubble it seemed like home prices were rising rapidly, so that even if a borrower would not be able to repay the loan he probably thought that he could sell the house at a profit as a last resort.  When housing prices stopped rising, the number of defaults on subprime loans started to rise sharply.

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