Nonprime is the New Subprime
Its been a while since subprime mortgages were in the news, but you may start hearing about them more in the coming months, with one caveat. Subprime mortgage loans are being rebranded as nonprime loans. This rebranding comes with some structural changes to the loans in an effort to make them safer and less likely to cause another default crisis.
What is a Subprime Loan?
A subprime loan is one offered to a borrower who does not have a strong credit history and may be likely to default. Keep in mind is that the “prime” being referenced in these terms is based on the borrower’s status, not the loan’s interest rate. A low credit score, usually under 660 or a high rate of debt, poor loan repayment history or unsteady income can all cause a borrower’s status to be considered subprime. These loans are offered at a higher interest rate than those of prime loans.
In many cases, there was no down payment required and borrowers’ income and assets were completely unverified. In 2006, over 90% of subprime loans were ARMs – Adjustable Rate Mortgages – which meant that payments began very low and quickly became hugely expensive, often outstripping the borrowers’ ability to repay the loan. One ominously-named ARM was the “Exploding ARM”, a loan with an interest rate that tripled after two years.
In 2005, $625 billion in subprime mortgages were originated. They were then packaged into mortgage-backed securities (MBS) and collateralized debt obligations (CDO) and sold to investors. Investors loved the ample rates of return that the higher interest rate mortgages offered. As the rates on the ARMs climbed borrowers began to default in massive numbers, leading to the subprime mortgage crisis.
After the housing crisis, federal regulators got to work banning many kinds of the high-risk mortgages that allowed the housing bubble to grow so large. Lenders also changed policies and started requiring much higher credit scores of their borrowers. The market for subprime loans fell off a cliff as the entire industry tightened up. In the first nine months of 2013, just $3 billion in subprime loans were originated.
What is a Nonprime Loan and How Does It Differ from a Subprime Loan?
Now the subprime mortgage market is beginning to come alive again, but with safeguards to avoid a repeat of 2008’s massive crisis. A nonprime loan is one offered to people who don’t meet the new Qualified Mortgage (QM) standards issued by the CFPB. QM standards state that the borrower’s debt-to-income ratio must be below 43%, their income and assets must be verified and the lender’s fees cannot exceed 3% of the total cost of the loan. Lenders are protected from legal action if their loans are QM, but non-QM loans do not offer this protection. If sold as a security, a lender may be asked to buy the loan back from the investor or “repurchase” it if a defect is found in the mortgage. Quality control reviews look for defects such as early payment default. EPD occurs when a loan is more than 90 days delinquent or in default status within its first year.
In order to create a safer loan with a lower chance of default, nonprime loans require up to a 30% down payment. Income and assets must now be documented and rate adjustments are smaller and take effect more slowly. However, investors still feel the burn of the crisis and are very wary to purchase the new crop of nonprime loans. Lenders are currently keeping the loans on their own books or selling them to private equity firms. While the FHA and Ginnie Mae are packaging them into bonds, investors continue to wait on the sidelines until they are sure these new loans are unlikely to default before they come back to the market.
Why are Nonprime Loans Needed?
So why does the American housing market need loans like this in the first place? Simply put, about a third of Americans don’t have a high enough credit score to qualify for today’s tighter lending standards. Those whose income is unsteady, like the self-employed, don’t meet standards either. Sustainable lending practices in both the prime and subprime markets will ensure Americans are able to move economic recovery forward.