Subprime mortgages: Loans for not-so-perfect credits.

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Subprime or bad credit mortgages were created to address the needs of borrowers with blemished credit histories. Unlike cookie-cutter Fannie Mae or Freddie Mac loans, subprime mortgages are offered by investors who vary widely in what they are willing to underwrite and how much they will charge to do it.

How Subprime Borrowers are Graded

There are varying degrees of credit-worthiness and many ways of evaluating it. Most lenders have a system that ranks prospective borrowers from a grade A (prime) to Alt-A or A-minus (typically low down payments coupled with fairly mild credit dings or a lack of income documentation), and then to true sub-prime candidates ranked B or lower. Generally lower ratings translate to higher required equity or down payment, higher fees and rates, and more restrictive terms. Some subprime lenders grade borrowers by credit score, typically 620-679 is A-, 580-619 is B, 550-579 is C, and 500-549 is a D. Anything below 500 is considered untouchable or nearly so. Other lenders skip the credit scoring and grade using a credit history matrix, for example:

Credit Grade B C D
Mortgage Credit History Two 30-day late payments in the last 12 mos. Two to four 30-day late payments in last 12 mos. and one 60 days late Various 60-day late payments in last 12 mos. and/or 90 days late
Revolving & Installment Credit History Majority paid as agreed in last 12 mos. w/ at least one 30-day late pmt. and one 60-day late pmt. Majority paid as agreed in last 12 mos. w/ at least one 60-day late pmt. and one or more 90-day late Last 12 months shows a pattern of being consistently late
Legal Liens, Bankruptcies, Foreclosures, Charge-offs    Minor (no foreclosure or large tax liens) or bankruptcy discharged > 24 mos. ago Minor (no foreclosure or large tax liens) or bankruptcy discharged > 24 mos. ago Any filing less than 12 mos. ago

To determine credit grades using this matrix, underwriters examine the applicant's credit history and assign the lowest grade corresponding to entries in the credit report. For example, if an applicant has two 30-day late mortgage payments but was on time with everything else, he or she would be rated a "B" borrower. However, if there was a foreclosure in the past 12 months the applicant is promptly dropped to "D." Disadvantages:  Obviously, subprime mortgages mean higher rates and fees. Borrowers stretching their income to make mortgage payments might be compounding their credit problems; if they find themselves unable to make all their payments it can perpetuate a cycle of poor payment history and force them to continue paying more for credit, further increasing the chance of missing payments. It may be wiser to spend 12 months making payments on time and reducing the amounts owed. This can increase the credit scores and improve matrix grades also.

Advantages: For borrowers with blemished credit but ample income, subprime mortgages can get them the home they want and help them reestablish a stronger credit history. Many subprime mortgages feature a period (two or three years) with a reasonable fixed rate. Following this period, the loan converts to a potentially ruinous adjustable rate with sky-high margins. The key to successfully managing these loans and salvaging credit ratings is to first make sure that the prepayment penalty (a fixture on nearly all these loans) expires before the loan converts to its ARM phase. Then make all payments (mortgage and other obligations too) on time, and finally, refinance out of the mortgage before the ARM payments kick in. Subprime loans can be a short-term step toward long-term financial health. In fact, they are often nicknamed "band-aid mortgages" because they give borrowers a chance to repair their credit and then move on to good credit mortgages.

Alternatives to Subprime Mortgages include reestablishing good credit by making all payments on time for at least a year (selling assets or taking on extra work to do this if necessary). Applicants in the "grey" area with scores from 580 to 660 can do a few things to keep themselves out of a B or lower rating. Increasing the down payment is a good way to lower the lender's risk and make a loan application more attractive. Opting for a cheaper house so that income isn't stretched quite so much also lowers the risk profile and may result in a better rate.

And finally, applicants on the prime/subprime "bubble" should start with Fannie Mae, Freddie Mac, or FHA lenders. Fannie Mae, for example, offers Expanded Approval programs that carry higher-than-prime but lower-than-subprime rates. Some of these loans even offer a 'Timely Payment Rewards' feature that lowers the mortgage rate when borrowers make their payments on time for 24 consecutive months. FHA loans offer flexible guidelines that don't use credit scores at all. They do analyze credit histories but are much more liberal about past bankruptcies or foreclosures, especially if there are mitigating circumstances and if the borrowers can show that they have reestablished good credit habits.

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