Why We Need Subprime Mortgages For A Healthy Housing Market

The phrase "subprime mortgage" conjures up images of the shady lending practices of the early 2000s, but the reality is that subprime loans are a vital part of a healthy housing market

Jun 22, 2014 at 1:00PM

Subprime mortgages are making a comeback, but don't worry about a repeat of the mortgage crisis anytime soon. Reforms have been implemented to ensure these loans are done responsibly, and lenders are requiring just as much (or more) documentation of a buyer's ability to repay as they would for a conventional loan.

Home Flickr Mark Moz

flickr/Mark Moz

Here's why things are different this time around, and why we need subprime mortgages to ensure the health of our real estate market.

What's a subprime mortgage, anyway?
The phrase "subprime mortgage" is associated with all of the mortgage scams and shady lending practices of the mid-2000's, but the reality is not so extreme.

Simply put, a subprime mortgage refers to any home loan where the borrower's credit is below normal lending standards. The word "subprime" has nothing to do with the amount of the down payment, variable interest rates, or any other characteristics of the mortgage itself.

But aren't these bad?
Now, I know a lot of readers are thinking that people with low credit scores shouldn't be able to buy homes; and that we're setting ourselves up for disaster again.

First of all, the average credit score for a rejected "prime" mortgage loan in the U.S. is currently 724. Anything over 720 is generally referred to as excellent credit. So, not everyone who can't qualify for a prime mortgage has bad credit.

Many actually have credit scores which would qualify them for the best rates on an auto loan or the best credit cards. It just so happens that credit for mortgages is still pretty tight on a historical basis.

Also, the terms of subprime loans are very lender-friendly. In other words, the risk of default is kept to a minimum, and in the event of default, the lenders are pretty well protected, as we'll see in a bit.

The differences the second time around
There are two big differences this time around, the Dodd-Frank act and the new "qualified mortgage" criteria lenders have to adhere to.

The Dodd-Frank act is designed to prevent borrowers from unknowingly getting in over their heads when buying a home. It protects against predatory lending practices, and requires mortgage paperwork to be clear and easy to understand.

And, as of January 2014, all mortgage lenders who engage in subprime lending are required to follow the "qualified mortgage" rules, which limit origination fees to 3% of the loan amount, and prohibit monthly payments of more than 43% of a borrower's pre-tax income. It also prevents lenders from offering such risky features as negative amortization or interest-only loans.

To obtain a subprime loan from a private (non-FHA) lender, you'll need a pretty large down payment of 25-40% of the loan amount, depending on the bank and your particular qualifications. So, in the event of default, the lender knows there will be sufficient equity in the home for them to recoup the entire amount of the loan. You'll also need to extensively document your employment status, income, and current debts.

Subprime mortgages are essential to the housing market
There are two main types of mortgages, other than subprime.

There are prime loans, which can be tough to come by without perfect credit and a high down payment. Then there are FHA loans, which can be had with very low credit and as little as 3.5% down, but cost an arm and a leg in mortgage insurance.

Subprime loans are necessary to serve those buyers who have less-than-perfect (but not bad) credit, but still have a down payment and all of the documentation required for a conventional loan. Considering that half of U.S. consumers have a credit score below 720, subprime mortgages play a large and essential role in bringing buyers, and therefore liquidity, into the housing market.

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4 in 5 Americans Are Ignoring Buffett's Warning

Don't be one of them.

Jun 12, 2015 at 5:01PM

Admitting fear is difficult.

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David Hanson owns shares of Berkshire Hathaway and American Express. The Motley Fool recommends and owns shares of Berkshire Hathaway, Google, and Coca-Cola.We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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