Sub prime mortgages were all over the news when the financial crisis hit in 2008. However, few still understand what the term “sub prime mortgage” means.
What is a sub prime mortgage? What should borrowers look for in sub prime mortgage lenders? We reached out to Elle Kaplan, CEO and Founding Partner of Lexion Capital Management and Mike Schenk, Senior Economist at the Credit Union National Association and Affiliates to talk about sub prime mortgages and sub prime mortgage lenders.
Sub prime mortgages are mortgages for people whose credit isn’t good enough to get the prime rate. When your credit score is lower than most, you will get a higher interest rate on your mortgage than someone with a better credit rating. “You’re a greater credit risk,” explains Kaplan, “the lender perceives you as being at greater risk of not paying back the loan, so you pay a higher interest rate.”
Schenk points out that Sub prime “isn’t necessarily a bad thing. It’s a financial product for a person who has had a few bumps along the way financially. So the real question is, as a lender, how do you behave toward people and where do you draw the line when making loans?”
The difference can be big, but it’s really impossible to make a single, sweeping statement about the difference between a prime and a sub prime mortgage in real terms. “Mortgages rates can be very expensive,” says Kaplan, “the difference in interest over the life of a loan can be tens of thousands of dollars.”
Kaplan always recommends that people go to credit unions instead of big banks because it’s easier to negotiate a better deal. This is because credit unions are non-profit institutions operated to maximize member benefits, rather than shareholder dividends.
Credit unions also have more of a vested interest in you paying back the loan. “Most credit union mortgages are portfolio loans, meaning that they stay on the portfolio of the credit union,” he says. This is in contrast to commercial lenders who often sold bad debt to the secondary market where it effectively became someone else’s problem.
Credit unions are also preferable for modest-income lenders because of lower origination fees. The average origination cost for a mortgage through a credit union is over $200 less than that of a mortgage obtained through a commercial bank. “It always pays to shop around and you should always include credit unions as a part of that process,” says Schenk.
Schenk recommends maintaining as much flexibility as possible when searching for a mortgage. “What you want to look for are lower rather than higher payments. You also want to avoid ‘shock payments’ that might occur.” These are drastically increased payments that result from having a variable-rate mortgage. “We all know that at some point rates are going to go up again,” he says, explaining that while the Federal Reserve says this will happen in 2015, if the economy improves it will likely happen sooner. Then anyone with an adjustable rate mortgage will see rate increases.
He says that in today’s market it’s pretty easy to compare different products and services. The trick is to get someone who is going to work with you to find the best product for your needs and tell you exactly what will happen when mortgage rates change. Kaplan recommends that you find out the difference between your rent and a mortgage and add some to that for expenses like homeowner’s insurance and things breaking that you can no longer rely on your landlord to pay for. This will help you to know whether or not you can afford a mortgage. “Live like this for a couple months and decide if you can afford it.”