A Subprime Mortgage: A Good Solution to a Bad Credit Problem

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This week we will focus on the positive. We will not, however, ignore the negative. First, let's look at both what subprime lending is and how big subprime lending is. We tend to think of the word "prime" in terms of the prime interest rate, but in this case prime means "excellent" or "perfect," and refers to creditworthiness. Subprime mortgages are home loans made at above-market interest rates to people with below-standard credit histories.

According to a recent report by the Mortgage Bankers Association, an industry trade group, there were more than $276 billion in subprime mortgage loans issued in 2003--roughly 14 percent of all mortgages. That's up from 11 percent in 2001.

Subprime loans are expensive. Depending upon how far from perfect your credit history is, the interest you pay can be as much as 5 or 6 percent above the going interest rate. As Raines points out, "A typical subprime loan can cost up to 400 basis points (4 percent) more than the same conventional loan. This means a family with a $120,000 mortgage will pay an extra $300 a month in interest payments. Over the life of a 30-year loan, that adds up to more than $100,000 in extra payments." This would be true if anyone actually kept a subprime loan for 30 years. As we'll see, in most cases you can refinance a subprime loan to a lower interest rate mortgage loan within a year to 18 months, as long as you maintain a good payment record.

Everyone goes through rough periods; times when money is exceptionally tight—maybe even nonexistent—and some bills just don't get paid on time. These rough patches get carefully recorded and documented by the three major credit reporting agencies: Experian, Trans Union, and Equifax. Reports from these three companies play a major role in determining the interest rate you pay on a mortgage, as well as on auto loans and other types of credit.

Unfortunately, some people just assume they fall into the subprime category without even checking. There are two ways to avoid ending up with a subprime rate when your credit is good enough to pay conventional rates. First, check your credit history to make sure there are no mistakes that could lead to a subprime loan. You can order your credit file from any of the big three credit reporting agencies: Equifax (800) 685-1111 or online at www.equifax.com, Experian (888) 397-3742 or www.experian.com, and Trans Union (800) 888-4213, or www.transunion.com. In most cases you will have to pay about $8 for a copy of your credit file. If you have been denied credit within the last 60 days, you will be able to obtain a copy of your credit file at no charge. Once you have a copy of your credit history you can look for mistakes. Each service explains what to do if you find one.

The second way to avoid a subprime loan is to shop for a mortgage. Few of us buy the first home that we look at; why would we buy the first mortgage offered? There are thousands of lending companies in the country. And while some people think it is "too expensive" to pay a few extra bucks so that more lenders can look at their credit reports, it's not "too expensive" when compared to paying an extra $300 a month a subprime loan might cost you.

If you find you will have to pay extra--that your credit history puts you in subprime country no matter which lender you talk to—remember this is a short-term situation. Instead of looking at the 30-year picture, look at how much extra a subprime loan will cost for just one year. In our example, it works out to $3,600. For 18 months, it would be $5,400. No matter how much it is, it is almost certainly tax deductible. Almost all mortgage interest is.

If you pay your mortgage on time and do the same with your other bills, at the end of a year or 18 months, you can start looking for a better rate. You'll probably be able to get it, too, because you have been making your payments on time for a year or more. You will also have equity in your home, further reducing the lender's risk. And it's usually easier to refinance than to get a new loan because you already own a home. All you're doing is looking for a better deal.

So don't think of a subprime loan as a huge 30-year debt. Instead, think of it as a short-term solution to a bad credit problem; a problem you can correct. Yes, the solution is expensive. But look at what you are getting for your money. If you wait until you have a "perfect" credit record before you buy a home, you will save money on interest, but you will have spent a lot more on rent; money that could have gone toward lowering your income taxes and building equity in a home of your own.