Subprime lending – an unsound practice in home lending

We’ve all seen the ads for “bad credit mortgages” or “no credit home loans no credit,” even though it’s alluring and admirable when it comes to enabling people to achieve the American Dream and own their own home , it’s not the most financially sound practice. Recently we’ve all seen the impact on our biggest home loan companies like Countrywide Financial and Citigroup, industry giants that once reported record profits are now struggling to stay afloat and others are on the verge of filing for bankruptcy. So why the sudden fallout? How can a catalyst in our economy cause such an economic downturn now?

The answer is subprime (less than ideal) home loans, when home lenders offer credit to consumers who don’t qualify for the best market interest rates. This often happens because of a bad credit history or financial adversity. Subprime lending also means the borrower pays a higher interest rate than a prime candidate who qualifies for an A-paper loan. This is a very risky situation, you are asking someone to pay more for a loan they may not even be able to handle financially. Why would a lender take this risk? This is because 25% of consumers fall into the subprime category, defined by a credit score of less than 620. And while the risk is greater, the reward is greater as well. Lenders can charge higher interest rates and add fees for lending to a subprime candidate.

The result of these practices has led to foreclosures and questions about how this happened and who is responsible. Some accuse the government of lack of control. Others have accused subprime lenders of predatory lending practices by offering loans they knew customers could not meet their financial obligations. Problems have also been raised with investors investing in subprime lending companies without due diligence on their portfolios. And these are just a few examples of the finger pointing now being caused by this crisis.

So to stay alive, subprime lenders are now borrowing from the Federal Reserve, Citigroup has borrowed $500,000,000 from the Federal Reserve on behalf of clients, according to the Financial Times. It is worrying that companies can borrow money to offset losses directly linked to risky lending practices. Given the financial implications associated with the economy, it would be better to have a clear plan to change these practices first. If you or I invested in a risky stock option, we would be responsible for the losses associated with that risk.

With this in mind, it is important as consumers to understand how we can protect ourselves. First, don’t commit to a home loan that you can’t afford financially. Second, before taking out a home loan, improve your credit score, consult a credit agency/counselor if necessary, but try to get your credit score above 680 to qualify for the best market interest rates. Third, work to lower your debt-to-credit ratio and get it below 35%. This is ideal for qualifying for a good loan. Below are the criteria for qualifying for an A-Paper loan, which means you are a prime candidate for the best market rates on your home loan.

  • In the United States, the borrower has a credit score of 680 or higher
  • The borrower fully documents his income and assets
  • Borrower’s debt-to-income ratio does not exceed 35%
  • The borrower keeps 2 months of mortgage payments in reserve after closing
  • The borrower contributes at least 20% equity

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