With Subprime Loans, Proceed With Caution

By Benny L. Kass
Saturday, October 7, 2006

Q: I am a first-time home buyer and thought that my credit was in good shape. However, when I applied for a loan, the lender told me that I could qualify only for a subprime loan, which would be at a higher interest rate -- and would require that I pay four or five points.

Exactly what is a subprime loan, and what should I do?

A: There are several things you should do, including immediately looking for another lender.

A subprime loan is generally made to persons who cannot qualify for a traditional mortgage. According to a recent study issued by the Federal Reserve Board, "The subprime category of residential mortgages includes loans made to borrowers that displayed one or more of the following characteristics at the time of loan origination: weakened credit histories stemming from payment delinquencies, charge-offs, judgments or bankruptcies; reduced repayment capacity as measured by credit scores or debt-to-income ratios, and incomplete credit histories."

You say that you have a decent credit rating? Have you obtained and reviewed your credit report? There are three major credit reporting companies -- Equifax, TransUnion and Experian -- and you can get a free credit report from each of these companies once a year. Go to http://www.annualcreditreport.com/ for additional information.

Perhaps one of these companies has erroneous information about you. If so, you should immediately explain this to your lender. They may be satisfied if you send them a written explanation. You should also contact the credit reporting agency with a written statement explaining the discrepancy.

Do you have any friends or relatives who may be willing to co-sign and guarantee your loan? Can you increase your deposit so that the amount of your loan will be lower than on the original application? As listed in the Federal Reserve analysis, "debt-to-income ratio" is often used as a justification for a subprime loan.

For example, if you applied for a 95 percent loan, and now are able to come up with more cash so that the loan is only 90 percent of the purchase price, the lower loan will reduce this ratio.

These are issues you should explore with your lender.

Additionally, you must talk with other lenders. Many subprime lenders are legitimate. They serve to allow people with bad or questionable credit to buy a house. While interest rates will be higher with a subprime loan, at least the borrowers will be able to pay a mortgage -- and get the benefits of appreciation and tax deductions -- instead of just paying rent.

Unfortunately, there are many disreputable lenders who just want to take advantage of borrowers. These are generally referred to as "predatory lenders," and there is a clear pattern to their operations.

You apply for a conventional mortgage, at 6.25 percent. The lender takes your information, and a few days later calls you back to advise that you cannot qualify for that low mortgage. However, he says, "We will give you a loan at 9.5 percent, with four points, and if you can demonstrate within one year that you have made all of the payments on a timely basis, you can refinance at regular rates."

Is this a legitimate lender, or are you the subject of a bait and switch? The predatory lender is prepared to make a loan to you with the expectation that you will quickly go into default, in which your house will be foreclosed upon, and the lender can start all over again with another innocent consumer.

One way to determine the bona fides of that lender is to shop around. Are other lenders reluctant to make you a conventional loan? If so, stick with your original lender -- but only if you carefully read the terms and conditions in your loan documents and are completely satisfied that you can make the monthly payments.

You should also contact such organizations as the Better Business Bureau, your local office of consumer protection and the Federal Trade Commission to determine the status of that lender.

The Department of Housing and Urban Development also has a strong interest in weeding out these predators. Recently, HUD issued a commentary on subprime lending, pointing out:

· Home refinance loans account for a higher share of subprime lenders' total originations than prime lenders' originations.

· A larger percentage of subprime lenders' originations are in predominantly black census tracts than prime lenders.

· Subprime lenders are more likely to have terms such as "consumer," "finance" and "acceptance" in their lender names.

A final note of caution: I hope that you have a financing contingency in your home-purchase contract that gives you the right to terminate your contract and get your money back if you are unable to obtain financing within a certain period of time.

Read that clause carefully. Because you have been rejected for a loan, and before your contingency expires, you should advise the seller (or the seller's agent) of that rejection, and either formally have the contract declared null and void or get an extension on the contingency period.

If you do not act, you will probably lose your earnest money deposit.

Benny L. Kass is a Washington lawyer. For a free copy of the booklet "A Guide to Settlement on Your New Home," send a self-addressed stamped envelope to Benny L. Kass, Suite 1100, 1050 17th St. NW, Washington, D.C. 20036. Readers may also send questions to him at that address.