What is a sub-prime loan? A sub-prime loan is a loan that is offered at rates and terms that are less desirable than those rates and terms offered to conventional borrowers.

How does a sub-prime loan differ from a prime loan? In the real estate industry, prime loans are usually referred to as conventional loans. As of this writing, a 30 year, conventional, fixed rate loan will carry an interest rate of just over 6%. By contrast, a sub-prime 2/28 Adjustable Rate Mortgage (ARM) loan might carry an 8% fixed rate for the first two years of the loan. Then, it turns into an adjustable rate loan. As an adjustable rate loan, it will likely carry an interest rate of about 11% based on today's rates. Sub-prime loans will normally have higher loans fees as well.

Who gets sub-prime loans? Normally, the people who get sub-prime loans are people with less than perfect credit or whose debt ratios are higher than allowed for conventional loans. However, some people end up with sub-prime loans simply because they take a loan from the first lender they talk to and don't shop around. Some lenders don't make conventional loans and there is little incentive for one of these lenders to tell you that you can get a better loan elsewhere.

What are the major drawbacks to sub-prime loans - There are several drawbacks to sub-prime loans.

Sub-prime loans have higher interest rates and fees than conventional, FHA, VA and most other types of loans.

The most common type of sub-prime loan is the 2/28 ARM described above. Borrowers need to understand and be prepared to deal with the higher payments that will occur when the loan goes passed it's fixed rate period.

Borrowers will not be able to refinance their loans if falling real estate prices drive a home's value below the amount of their loans.

Most sub-prime loans have prepayment penalties. The prepayment penalty period may go beyond the time at which the loan becomes adjustable.

The Bottom Line - Sub-prime loans are not for everyone. In fact, they have gotten a lot of negative press lately. Sub-prime loans are targeted toward high risk borrowers who can't qualify for other, more favorable types of credit. Not unexpectedly, during downturns in the real estate market, these high risk borrowers suffer more foreclosures than typical borrowers. Because of the media attention surrounding the sub-prime lending market, Congress seems poised to jump on the bandwagon which is a shame.

The vast majority of people who have taken sub-prime loans do not lose their homes to foreclosure. Literally, there are millions of Americans who own homes because of sub-prime loans who would not otherwise have been able to qualify for a home loan. Normally, these borrowers keep their sub-prime loan until they can clean up their credit and refinance into a conventional loan. Only a small percentage of these loans actually go to foreclosure and these borrowers, for the most part, had no downpayment or have taken all of the equity of their homes through home equity loans.

It is estimated that 20% of the real estate loans made in 2006 were of the sub-prime variety. Many sub-prime lenders have gotten out of the market recently because their loses were more than they were willing to take. Action by Congress will push more buyers out of the market and cause real estate prices to drop farther.

My advice - Make sure that you study the Truth in Lending statement the lender is required to give you and know all of the terms of the loan including any changes that might occur in the future (as with adjustable rate loans) and what impact those changes will have on your ability to repay the loan as agreed. Be sure to ask if there is a prepayment penalty. Also, use a trustworthy lender.

How do you find a trustworthy lender if you don't live in the Yuba City area? - Experienced people in the real estate industry know who the trustworthy lenders are in any given area. Find an experienced real estate agent in your area that you trust. They will be happy to refer you to good lenders in your area. Or, if you know an escrow officer at a local escrow or title company you can ask them.

Last updated March 29, 2007