WASHINGTON — There is a language of money, complete with its own vocabulary. It’s in your interest to know as much of the terminology as you can, so don’t be too embarrassed to ask what something means.
One participant during a recent online discussion asked me a question that some might dismiss as naive. But it was a question that many people should have asked before they bought their homes. After all, in a recent survey commissioned by bankrate.com, 34 percent of homeowners with mortgages didn’t have a clue as to what type of loan they had.
“There have been many stories in the news about subprime loans,” the reader wrote. “What exactly is a subprime loan? And what exactly is the problem with defaulting on a subprime loan versus a prime loan? Are there signs to watch out for when you are discussing mortgages with a bank or a lender?”
You need to know that there are three lending worlds out there. One world is for borrowers who are ready for prime time loans — they easily qualify for a lender’s best interest rates. Depending on the lender, scores in the low 700s and above put you in prime territory.
In the current interest rate environment, if you’re a creditworthy customer also known as a “prime” borrower, you should qualify for a mortgage interest rate that is less than the prime rate, which is currently 8.25 percent.
In the middle is not-so-prime-time lending — or the “Alternative-A” mortgage world. These loans are made to people who are considered less risky than a subprime borrower but aren’t as creditworthy as someone in the prime category. Alt-A borrowers, as they are also called, can have high credit scores but may not be able to verify their income. Generally, the rate these borrowers pay is lower than a subprime loan. This sector is also having payment trouble.
The furthest from the prime world is the subprime market. Subprime loans are typically made to borrowers who have spotty credit records. The interest rates on these loans are usually at the prime rate or higher.
Subprime loans include nontraditional products with terms allowing borrowers to pay interest only or offering adjustable rates that are subject to sudden spikes after a certain time.
Generally you enter subprime territory when you have a credit score in the low 600s. Each lender sets its own benchmark for subprime customers.
One lender may set the bar at a credit score of 650 or below, another might set the bar at 620.
But a low credit score isn’t the only factor that may push you into a subprime loan. You might only qualify for such a loan if you have a low downpayment or you can’t accurately document your income.
In the case of home loans, the subprime borrowers you’re hearing about these days are defaulting because market conditions have made their mortgages more expensive. Many people with adjustable-rate loans have seen their rates jump as other short-term interest rates have risen, pushing up their monthly payments. Others took out loans with teaser rates hoping they could refinance into better loans. When they couldn’t because their income fell or their home’s value declined, they got stuck with mortgage payments they couldn’t afford.
By the end of the year, as many as 2 million subprime borrowers could lose their homes to foreclosure, according to the Center for Responsible Lending, a nonprofit, nonpartisan research and policy organization.
There is no difference between defaulting on a subprime loan and a prime loan. Although the news has focused on subprime borrowers, even homeowners with favorable mortgage terms are having trouble. The delinquency rate for all major types of loans — prime, subprime, FHA, and VA — increased in the fourth quarter of 2006, as did the foreclosure rate, according to the Mortgage Bankers Association.
The last question — what to watch out for in a mortgage loan — is one all borrowers should be asking. The Center for Responsible Lending, which has been highly critical of subprime lenders, lists some of the things to look for and avoid in a mortgage loan:
- Excessive fees. Don’t be so quick to get a home loan that you ignore the fees. Mortgage lenders often disguise or play down fees because they are often rolled into a loan.
- Prepayment penalty. A mortgage with a prepayment penalty option requires you to pay a penalty or fee if all or most of loan amount is repaid within a certain time period (generally ranging from two to five years from the start of the loan).
- Loan flipping. Despite the rise in foreclosures, the offers to refinance are still plentiful.
But crunch the numbers. Some refinance deals generate lots of fee income to the lender but provide little financial relief to the borrower.
Like this chat participant, I wonder how many people reading all the news stories couldn’t really explain the current subprime mortgage meltdown. It’s certainly true that many prime and subprime borrowers who are facing foreclosure didn’t understand the language and terms in the loans they got.