Non-traditional mortgage market expands

With an increasing number of lenders offering subprime loans, borrowers identified as high risk should find that lenders are not as quick to ignore them as in the past. Nearly every major institution is entering the non-traditional lending market. Consequently, more borrowers that do not meet the traditional credit criteria should qualify for mortgages. As this market expands, vigorous competition among lenders willing to take on more default risk will produce better rates.

Subprime mortgages are made to borrowers that do not meet the traditional credit criteria or to people with unconventional borrowing needs, including those for loans that exceed 100 percent of the property’s value. Issues preventing borrowers from meeting the traditional criteria could be a low downpayment, high debt ratio or low reserves at settlement and past credit problems: bankruptcies, defaults, foreclosures and chronic late payments on debt obligations.

Non-traditional mortgage lending is categorized into credit grade categories based upon the person’s creditworthiness.  A borrower will typically fall into one of five categories: A, A-, B, C, or D. Several factors contribute to the credit grade on non-traditional lending such as past credit history, debt ratio and income documentation. The more serious the credit problems and higher debt ratio, the lower the grade. Lenders will assess a lower grade on loans when little or no documentation is provided to substantiate the borrower's income.

As the grade on loans decreases, lenders generally assess higher rates and fees. Until recently, the evaluation of loan applications was left to human underwriters who relied on their own judgment to categorize loans by risk level. Using of computerized loan-evaluation systems capable of forecasting the default risk dictated by each mortgage, allows lenders to determine the individualized interest rates charged to each borrower. The lower-risk borrower will receive a lower interest rate than the higher-risk borrower.

Should you get a mortgage loan with a prepayment penalty?

Prepayment is the payment of all or part of the mortgage debt before it is due. Prepayment-protection mortgages (PPMs) restrict the right to prepay the loan without penalty in its early years. A prepayment penalty is a fee charged by the lender to the borrower who wishes to repay part or all of the loan in advance of the regular schedule. Mortgage companies introduced prepayment penalties on mortgage loans as a way to offer lower interest rates to borrowers who do not expect to prepay.

When people pay off a mortgage loan early, investors supplying the capital to fund mortgages must find an alternative investment vehicle that pays an equivalent return. This costs investors time and money. So, investors agreed to offer a lower interest rate if they could receive some compensation for prepayment losses. Most mortgages with prepayment penalties have an interest rate one- quarter percent to one full percent below those without penalties. The lower interest rate charged for PPMs allows borrowers to reduce the cost of purchasing a home. Many borrowers that couldn't be qualified for market rate mortgages could be qualified for a lower rate PPM mortgage.

Most prepayment penalties today do not extend beyond first three or five years after loan origination. If the sale of the home creates the prepayment, borrowers usually does not incur a prepayment penalty. Some PPM mortgages allow you to prepay up to twenty percent of the original mortgage amount in any twelve month period without any penalty.

Second mortgage market investors, like Freddie Mac and Fannie Mae, began funding some PPMs. One of the Freddie Mac PPM products limits the prepayment moratorium to three years and the penalty to 2 percent of the remaining loan balance. The other PPM product consists of a five-year moratorium with a prepayment penalty equal to six months’ interest on the remaining balance. Growing standardization within the PPM product line will make it easier for borrowers to understand PPMs and then ask for them.

So, should you get a mortgage loan with a prepayment penalty? Generally, it is not wise if you intend to refinance or pay off your loan in less than three to five years. If you plan to keep the loan for more than five years, you can take advantage of a lower interest rate on PPM mortgages. Be sure you completely understand prepayment penalties. If anything occurs you don't understand, always question it. Prepayment penalties are just another aspect of the mortgage process which needs to be evaluated.

The availability of 7/1 and 10/1 ARMs proliferates

The number of lenders willing to offer 7/1 or 10/1 ARMs  has increased over the past year. According to Freddie Mac’s nationwide survey 64 percent of the lenders are offering a 7/1 ARM -- 16 percent up from the previous year. Fifty-two percent of lenders are providing a 10/1 ARM compared to 45 percent in 1996.

7/1 ARM is a 30 year loan with interest rate and payment fixed for initial period of 7 years. At this time, the interest rate and payment changes once every year for the remainder of the loan. 10/1 ARM have same terms as 7/1 ARMs, only initial period is 10 years.

The main advantage associated with these types of loans is that homebuyers get a slightly lower rate than the 30 year fixed loans to begin with. For homebuyers who remain in the home for seven to 10 years before moving these types of loans present an excellent way of getting a fixed rate loan at a better th an market price for a fixed period of time.