CA borrowers shifting from FHA to subprime mortgages
By ANDREW LePAGE
2/8/2005

SACRAMENTO, Calif. -- Not so long ago, someone looking to buy a house fit squarely into one of two boxes: Based largely on credit score, the borrower either qualified for a "prime" loan with the lowest rate and best terms or had blemished credit and was stuck with a more costly "subprime" mortgage.

Today the lines between prime and subprime are blurring as more lenders take aim at borrowers who don't fit the rigid mold of prime mortgages. That allows more people to buy their first house or spend more than they otherwise could, helping to explain how California's housing market could be so hot when home prices are soaring but jobs and incomes are not.

"The biggest factor is that subprime lending has opened the door to homeownership to people who have been shut out for income, credit or (lack of) asset reasons," said Ted Grose, the California Association of Mortgage Brokers' research director.

Competition among lenders -- hungry for business after the end of a record refinancing boom -- has driven many to expand subprime offerings, lower costs and improve terms, especially for borrowers with higher credit scores.

Most subprime loans are still used for refinancing, but more and more are used by people stretching financially to buy the home of their dreams. Subprime loans, which often have big prepayment penalties, allow many buyers to put up to 55 percent of their income toward housing, even with no money down and interest-only payments.

Last year, 17 percent of the nation's estimated $1.03 trillion in total purchase loans were subprime, up from 11 percent in 2003, said SMR Research, a Hackettstown, N.J., firm that tracks financial markets.

Figures weren't available for the percentage of 2004 purchase loans that were subprime in California, but the overall use of subprime was way up.

Total subprime lending of $197 billion in California last year was more than double the 2003 total.

"All of this talk about low (housing) affordability is just not recognizing all of the different financing instruments that have resulted in this Niagara Falls of easy money for home loans, and subprime is one aspect of this," said G.U. Krueger, chief economist at Institutional Housing Partners, an Irvine, Calif. investment firm.

"It used to be that if you were subprime you couldn't buy a home, or it was really hard or really expensive, and now they have all kinds of subprime providers," Krueger said. "It's actually getting relatively affordable. A whole bunch of people who wouldn't have been in the market four or five years ago are now in it and it...may have permanently taken the number of home buyers to a higher level."

Federal policy supporting homeownership has stimulated mortgage innovation and driven demand for homes, he said, but California policy hasn't enabled the supply of housing to keep up and prices have soared.

A decade ago subprime loans typically had interest rates 4 to 6 percentage points higher than those for a prime loan, but the typical difference now is 2 percentage points, said SMR President Stu Feldstein.

Some borrowers with good, but not great, credit scores can pay a difference of less than three-fourths of a percentage point.

John Walsh, branch manager at subprime lender First Franklin Financial in Sacramento, shows how a couple earning $46,500 -- below Sacramento County's median income of $51,300 for a family of two -- could qualify to buy the county's median-priced home of about $320,000.

The subprime loan Walsh has in mind requires no money down but has $10,000 in closing costs. It has a fixed interest rate of about 6.625 percent for two years. After that it adjusts every six months based on the commonly used "LIBOR" index plus 4.25 percentage points.

The loan also has interest-only payments for five years, after which the loan is reamortized over the remaining 25 years and the borrower begins paying on the principal, too.

Walsh assumes the couple has a decent FICO credit score of about 660, no other monthly debt and is willing to devote 55 percent of their income toward housing, the maximum under subprime.

The couple also would face a prepayment penalty amounting to $8,300 if they ditched the loan during the first two years.

The same couple wouldn't be able to spend more than about $240,000 on a home with a conventional loan and a 5 percent down payment and closing costs, Walsh noted.

Among those flocking to subprime lenders are many who traditionally would have opted for a low down payment, government-insured FHA loan but now have to look elsewhere.

The Federal Housing Administration loans, which allow borrowers to have less-than-prime credit, have a cap that hasn't kept pace with home prices and doesn't allow the popular adjustable-rate, interest-only combo, industry analysts said. In 2003, 4.7 percent of all purchase loans in California were FHA, down from 8.9 percent in 2002, the national Mortgage Bankers Association said.

Many sellers and real estate agents are averse to FHA borrowers because the agency requires pest work and other improvements recommended by its appraisers or inspectors be completed before the deal closes. In today's hot housing market, sellers of entry-level homes typically won't pay for such work.

While many in the lending industry credit subprime loans with helping to boost the nation's homeownership rate, now at a record 69 percent, the loans have also raised concerns about whether home buyers are setting themselves up for financial disaster. Subprime lenders argue that some elevation in loan defaults is expected, but most borrowers will be fine.

"When you open the door to people who don't fit the conservative qualifying box you'll do two things: Increase homeownership and the stability that brings, but you'll also increase delinquencies and foreclosures, and they (lenders) pay the price for that," Grose said. "It's why it's called risk-based pricing."

But experts say higher mortgage rates and flat-to-lower home prices would mean more foreclosures.

A University of North Carolina, Chapel Hill, study released this month found that subprime prepayment penalties and balloon payments put borrowers at greater risk of foreclosure.

"I think there's going to be hell to pay," said Jeff Tarbell, president of Sacramento's ATM Mortgage, referring to subprime loans with short fixed-rate periods. "I don't know when it's going to be but there will be...payment shock for those committing themselves to a short-term financing solution without a strategy to cope with the rate change in two or three years."

Distributed by Scripps-McClatchy Western Service
www.shns.com

Article © MortgageDaily.com All Rights Reserved