It's buyer beware when you're
shopping for a subprime loan
By Michael D. Larson • Bankrate.com

Outlaws knew not to go after money in the Wild, Wild West without being able to use a six-shooter. But borrowers may not realize they need just as much training before striking out for a subprime mortgage -- the high-interest loan offered to those with imperfect credit.

Unlike the conventional mortgage market, the market for subprime home loans is as confusing, daunting and full of potential pitfalls today as the 1800s world of the Earps and the Hickocks. Mortgages for people with damaged credit vary widely from lender to lender, with rates, terms and pricing all over the map. That means borrowers better learn how to shop before they start.

"The conforming business is essentially a commodity business. The rules are fairly cut and dried, everyone's competing and most of the paper ends up getting sold to the agencies," Fannie Mae and Freddie Mac, says Laird Minor, executive vice president of structured finance and credit policy at HomeGold Financial Inc. The Greenville, S.C.-based company makes first and second subprime mortgages. "There's little variation in the credit risk involved and in a commodity business, you're competing essentially on price.

"In the subprime world, every loan is individual and every borrower's story is unique," he adds. "You have different considerations and what you're trying to do is make sure you understand the risks in any particular loan and price appropriately. But how I assess risks may be entirely different from how someone else does."

Understand how things work
To understand why, consumers need to understand how things work in a mortgage lender's back office. Most sell their conventional loans to Fannie Mae and Freddie Mac. The two agencies either hold the loans in their portfolios, making money off the payments people send in, or bundle them together into mortgage-backed securities, which are then sold to Wall Street investment companies.

Because the agencies dominate that part of the business, most lenders and brokers receive roughly the same price for their loans. That means rates charged to consumers vary little from one lender to the next. Fannie Mae and Freddie Mac set underwriting standards that loans have to meet before they'll buy them, too. So, lenders follow pretty much the same guidelines when deciding whether to make a loan.

On the subprime side, mortgages and home equity loans can end up in any number of places. Large finance companies buy some of them. Investment firms buy others for packaging into a different variety of mortgage-backed securities. Some are even held in portfolio and serviced by the lenders making them. That means subprime originators have much more leeway when it comes to setting rates and underwriting standards. As a result, rates, fees and program guidelines vary drastically depending on which broker or lender a consumer visits.

"It really ultimately boils down to where these loans are sold," says Kirk Smith, president of SouthStar Funding. The Atlanta, Ga.-based company is a wholesale subprime lender, or one that makes loans through brokers. "You don't have the same consistency from lender to lender because everyone's operating under different underwriting guidelines."

Devote extra time to shopping for mortgage
Because that's the case, subprime borrowers need to spend much more time shopping lenders and brokers than their conventional counterparts. Each company will likely offer different rates and fees for the same types of loans, depending on which investors they turn to for financing.

Damaged-credit consumers should hone their negotiation skills, too. Subprime lenders have much more leeway to adjust their rates because their margins, or differences between what the money costs them and what they lend it out at, are wider than those typically found at conventional lenders, experts say.

"Mortgage lenders do have investors whom they have to keep happy and they have to package the product in ways that investors will buy it, but there can be ways to negotiate within that," says Ron Day, group executive for consumer lending at Centura Banks Inc. The Rocky Mount, N.C.-based company owns part of First Greensboro Home Equity, a retail subprime lender.

"Keep all your options open and try to talk to as many lenders as you can."

How to save some money
There are other less obvious ways savvy subprime borrowers can save money, too.

Consider that subprime lenders grade customers the same way that elementary school teachers grade children. Depending on an applicant's credit score, debt-to-income ratio, ability to verify income and other variables, a lender or broker assesses a letter grade that typically ranges from "A+" down to "D." The loan officer then charges a rate appropriate to that category. Because the distinctions between categories are often slight, borrowers can move up the scale without much effort.

For example, lenders tend to grade people based on how many times they were 30 or 60 days late with their mortgage payments in the past year. Having two "30-day lates" might push them into the "A-" category while having just one would keep them in the "A" zone. As a result, a customer who was late twice, but one of the late payments was 11 months ago, can improve a notch by just waiting a few extra days to borrow. By doing so, that customer could save a half a percentage point, or 50 basis points, on the interest rate, according to pricing sheets wholesale lenders send to mortgage brokers.

Scrounging up a few extra dollars can make a big difference, too. Lenders generally adjust their rates lower for each 5 percent drop in a mortgage's loan-to-value ratio -- the difference between the loan amount and the value of the property securing it. Someone with a $100,000 home who wanted to pay off debt by refinancing could save 50 basis points by getting a $79,900 loan rather than an $80,100 one.

Of course, knowing how to avoid rate hikes is just as important as knowing how to earn rate breaks. That's why borrowers might find it interesting to learn that lenders provide brokers with a list of things that will boost a borrower's rate. Some are things people have no control over. After all, if you're buying a condominium, you're buying a condominium and you'll probably have to pay half a percentage point more to do it.

What you CAN change
But other variables can be manipulated or taken out of the picture altogether. Think twice about withholding documents to prove income and assets, for example. That's because you'll get a "no doc" rate, which can be as much as a full percentage point higher than a regular one. Also, try to pay off some bills before applying, because a debt-to-income ratio of more than 50 percent can add 50 basis points to the loan rate.

Be sure to scrutinize any prepayment penalty as well, because most subprime loans come with them. You might be able to lower your rate by accepting a longer-duration penalty, such as one that lasts for five years, but you may not want to do so. That's because you'll probably be able to refinance into a conventional loan before the penalty expires because it only takes one or two years to rebuild credit these days.

If all of this sounds confusing, it is. For an illustration, just look at Charlie Cartwright's company, LenderBase Corp. of Denver. The firm runs an Internet site where mortgage brokers can log on and search loan programs to find ones that match up with what their borrowers need.

"In conventional lending, you're dealing with borrowers with high credit scores, solid income and single-family residences -- real vanilla, basic borrowers," Cartwright says. "In subprime, you're dealing with people who can't prove any income, have low scores, have had bankruptcies, have way too much credit or need higher loan to values on their property."

"There's just thousands of different variations."

And thousands of ways an unprepared customer can get taken for a ride in the borrower badlands.