Subprime refinancing options are shrinking

By Bankrate.com

Lenders have abruptly stopped offering the most popular type of subprime mortgage. Credit-challenged borrowers suddenly have fewer options.

"Many borrowers are not going to be able to refinance," says Deborah Goldstein, the executive vice president of the Center for Responsible Lending.

The consumer watchdog group has criticized loose standards for subprime mortgages, which are home loans for people with problem credit -- generally, with credit scores below 620.

Over the past few years, the most common type of subprime loan has been an adjustable-rate mortgage known as the 2/28 ARM. Since mid-July, five of the six biggest subprime mortgage lenders stopped offering 2/28 ARMs. Suddenly, there's a shortage of the type of mortgage preferred by about 60% of subprime borrowers.

"We think it's a good thing for consumers," Goldstein says, because too many 2/28 ARMs were underwritten without regard to whether borrowers could afford to repay them. "So we think it's positive that lenders are going to stop offering that product. It doesn't mean they'll stop offering subprime loans."

A 2/28 subprime ARM has a low initial rate that lasts two years. After that, the loan resets, which means that the rate is adjusted upward or downward. At the first jump, the rate can conceivably climb 2 to 6 percentage points, causing monthly payments to skyrocket. (In practice, the first rate jump is usually on the smaller end of that scale, but it can keep rising every six or 12 months after that.)

What's a refi customer to do?

Mortgage brokers and loan officers say borrowers who need to refinance their subprime mortgages still have options -- just not as many. Some lenders might still offer 2/28 and 3/27 ARMs, although the rates might be high, possibly into the double digits.

And some lenders offer 5/25 ARMs and 30- and 40-year fixed-rate subprime mortgages. In addition to that, there are "expanded approval" loan programs, which allow lenders to offer Fannie Mae-approved loans to people with blemished credit, but borrowers have to document their incomes, pay principal as well as interest, and, in most cases, pay mortgage insurance.

"It's old-school again," one mortgage banker sums up.

Federal Housing Administration-insured loans are another option, as long as the borrower has at least 3% equity in the house. Loans insured by the Department of Veterans Affairs don't require a down payment.

What about homeowners who face an impending rate reset that will send their payments to unaffordable levels but can't qualify for a refinanced loan -- either because of insufficient payment history and income or because they owe more than the house is worth?

"Some families are going to have to make ugly decisions," a banker says, by cutting back on spending or, in the worst case, losing their homes in foreclosure.

Cause and effect of easy borrowing

Underwriting for subprime ARMs was so lax in 2005 and 2006 that hundreds of thousands of borrowers fell behind during the initial two-year period, before their loans reset and the payments jumped.

Continued: Risky mortgages

 1 | 2 | next >