Is the Subprime Mortgage Coming Back?

Is the subprime mortgage creeping back into the housing marketplace? What about other forms of financing with variable rates and special features? Several consumer authorities say "yes," and argue that some forms of real estate financing should largely be banned.

Writing in The American Banker, John Bryant and Robert Gnaizda argue that "a number of financial institutions are considering or have already introduced potentially dangerous ARMs, including interest-only mortgage products."

Actually though, the better argument is that today's mortgage market is filled with boring, low-risk mortgages, the kind that prevent foreclosures and lender losses. Under Dodd-Frank -- aka Wall Street Reform -- lenders are allowed to offer interest-only financial products. That's a fact but it's not the whole story.

Wall Street Reform divides the mortgage marketplace in two: First we have "qualified mortgages" or "QMs," the loans we most commonly see today. These are FHA, VA, conventional and portfolio mortgages which meet certain standards. Second, we have "non-qualified mortgages" or "non-QMs." A jumbo loan or non-conforming mortgage is a good example of non-QM financing.

Why Lenders Like Qualified Mortgages

In the past few years, mortgage lenders have paid out more than $100 billion to settle improper lending claims. You can imagine that lenders don't want to pay out any more fees to lawyers, borrowers, investors and insurers and this is one reason they favor QMs -- a lender who makes QMs is virtually immune from liability.

The catch is that loans must meet certain standards before they can be regarded as QMs. For instance, with a QM, points and fees are generally limited to not more than three percent of the loan amount. With qualified mortgages, all payments must be substantially equal, meaning that interest-only loans and financing with balloon payments are out. Loans cannot be more than 30 years in length.

You can have interest-only loans and balloon payment mortgages that are non-QMs; however, even with non-qualifying mortgages there are still rules which must be followed.

The most important is the Ability-to-Repay standard. This rule says lenders must show that the borrower has the financial strength needed to repay the loan. At first this sounds like a pretty-minor requirement but the implications are significant. As the Consumer Financial Protection Bureau explains, "lenders will have to determine the consumer's ability to pay back both the principal and the interest over the long term − not just during an introductory period when the rate may be lower."

Because of Wall Street reform, so-called "stated income" home loans are no longer allowed -- lenders have to verify the borrower's income. Equally important, lenders can no longer qualify a borrower on the basis of ARM teaser rates. Instead, they have to show that the borrower's income is sufficient to support the loan even if monthly costs increase.

The Subprime Mortgage

We had the subprime mortgage before and we have them today. In fact, you can have a subprime loan which is actually a qualified mortgage. "A subprime mortgage," says the CFPB, "is generally a loan that is meant to be offered to prospective borrowers with impaired credit records."

In other words, a subprime loan does not have to be a predatory financial product. It can simply be a loan with a stiff interest rate, a rate which reflects the risk of lending to someone with poor credit.

Prepayment Penalties

One reason many borrowers could not get out from under the toxic loans that lead to the mortgage meltdown is that there were stiff prepayment penalties for early loan payoffs, sometimes $10,000 or more. Under Dodd-Frank those days are over. A non-QM loan cannot have a prepayment penalty.

But what about qualified mortgages? Under the new rules, QMs can have prepayment penalties, however consider these two ideas: First, there are no prepayment penalties with such QMs as FHA, VA and conforming (Fannie Mae and Freddie Mac) loans.

The only place where you can now find a prepayment penalty might be with fixed-rate portfolio loans which meets all QM requirements.

Second, prepayment penalties are now limited to not more than two percent of the loan balance during the first year, two percent the second year and one percent in the third year. After that, zero. There can't be any prepayment penalty.

When you're done going through all the rules -- and there are a lot of rules to go through -- the bottom line is this: even when loans have the same names as products offered before the mortgage meltdown, they're just not the same financial products. What we have today are dull, boring mortgages, precisely the kind of mortgages that reduce foreclosures and excess lender risk.

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