Subprime mortgages are often associated with borrowers who have a tainted or limited credit history. This is because a subprime mortgage can offer a consumer a way to purchase a home while they repair or build their credit history. Because subprime mortgages carry substantially higher interest rates than similar mortgages available in the prime mortgage market, a subprime mortgage borrower has a great deal of incentive to repair or establish his or her credit to be able to refinance the subprime mortgage into a prime mortgage.

Many subprime mortgage programs have been designed with this in mind and, as such, they are intended to be relatively short-term financing vehicles. Adjustable-rate mortgages (ARMs) with either a two-year, fixed interest rate period (2/28 ARMs) or a three-year, fixed interest rate period (3/27 ARMs) are common subprime mortgages. (To read more about ARMs, see ARMed And Dangerous and American Dream Or Mortgage Nightmare?)

In this article, we'll discuss how subprime borrowers need to understand, identify and measure the risks associated with borrowing under such a short-term horizon.

Subprime 2/28 and 3/27 ARMs
A subprime 2/28 ARM is an adjustable-rate mortgage with an initial two-year, fixed-interest rate period. A subprime 3/27 ARM is an adjustable-rate mortgage with an initial three-year, fixed-interest rate period. They are the equivalent in the subprime mortgage market to what is commonly known as a hybrid or fixed-period ARM in the prime mortgage market.

After the fixed interest rate period, the interest rate starts to adjust according to an index plus a margin. The index value plus the margin is known as the fully indexed interest rate. For example, 2/28 ARMs are frequently tied to the six-month LIBOR index. If the six-month LIBOR index is 6% and the margin on the loan is 5%, the fully indexed interest rate will be 11%. Subprime 2/28 and 3/27 ARMs carry a higher fixed period interest rate and a larger margin than prime fixed period ARMs. (Keep reading about this subject in Mortgages: Fixed-Rate Versus Adjustable-Rate.)

Subprime 2/28 and 3/27 ARMs frequently have prepayment penalties. A prepayment penalty is a provision in the mortgage contract that requires the borrower to pay a certain percentage of the mortgage's remaining principal balance or a certain number of months' interest if the mortgage is paid off before the end of a prepayment penalty period. Subprime 2/28 and 3/27 ARMs sometimes have prepayment penalty periods that are longer than the fixed-interest rate period.

Interest Rate Caps
Subprime 2/28 and 3/27 ARMs sometimes lack interest rate cap structures. An interest rate cap structure limits the amount by which, and the rate at which, the fully indexed interest rate can increase at each scheduled interest rate adjustment date and/or over the life of the mortgage.

Because many subprime borrowers intend to refinance their adjustable-rate mortgage before, or at the end of, the fixed interest rate period, they frequently do not pay attention to how the fully indexed interest rate is calculated, ignore the mortgage's interest rate cap structure, or are sometimes ignorant of the fact that the mortgage has a prepayment penalty.

These are big mistakes. The index, the margin, the interest rate cap structure and a prepayment penalty are all very important. Borrowers need to know and understand how the fully indexed interest rate is calculated, and need to be aware of any prepayment penalties.

Short Time Horizons Carry Substantial Risk
Subprime borrowers who intend to use a 2/28 or 3/27 ARM as a short-term financing solution while they repair their credit can face the following risks:

1. Prepayment Penalty
Unscrupulous mortgage lenders have been known to slip prepayment penalties into the mortgage contract at the last minute, and/or without the borrower's understanding of the potential financial consequences. A prepayment penalty should never have a time period longer than the fixed interest rate period on the mortgage.

2. Payment Shock
If the mortgage cannot be refinanced as planned before the end of the fixed-interest rate period, there is a high probability that the fully indexed interest rate will be higher than the initial fixed interest rate, which could lead to a substantial increase in a person's monthly payments.

While no one can predict with certainty the future direction of interest rates, borrowers should have an understanding of the probable future course of both long and short-term interest rates, and know how future interest rates will affect their current mortgage and the interest rate on the mortgage that they intend to refinance into. Ideally, a borrower should run scenario analyses based on varying interest rate courses, and identify and measure the risks associated with varying future interest rate outcomes. (To learn more about interest rates, see Trying To Predict Interest Rates and Forces Behind Interest Rates.)

3. Weak Price Appreciation
This risk involves a borrower's home equity and the rate of home price appreciation. Many subprime borrowers, sometimes based on a lender's advice, assume unreasonable amounts of home price appreciation over the short time period they intend to keep the 2/28 or 3/27 ARM. They count on future home price appreciation to pay for the costs of refinancing their mortgages down the road, as well as allowing them to obtain future mortgages with more favorable terms based on the increased equity in their homes. (A mortgage's loan-to-value ratio (LTV) is a primary measure of risk by lenders when grading borrowers. To learn more, see Make A Risk-Based Mortgage Decision.)

Past rates of home price appreciation are not a good indication of future rates. Borrowers who count on substantial home price appreciation over a short time horizon to help them refinance out of their existing mortgages are taking on a great deal of risk. Ideally, a borrower should run scenario analyses based on varying rates of home price appreciation, as well as identify and measure the risks associated with various home-equity scenarios.

A Potential Alternative to Subprime Borrowing
The federal government, working with state and local governments, spends a lot of money to promote homeownership. A borrower with a tainted credit history and/or little to no down payment would be wise to check into government-sponsored mortgages. Government-sponsored mortgages typically carry lower interest rates and costs than subprime mortgages. Government-sponsored mortgages include Federal Housing Administration loans, Veterans Administration (VA) mortgages, and mortgages sponsored by state and local governments.

These mortgages can require a shorter history of clean credit and smaller down payments than conventional mortgages. Even if a borrower might not qualify immediately for such a mortgage, it might be a more economically sound decision for a borrower to stay in his or her current situation, including a current mortgage, until qualifying for a government-sponsored mortgage, rather than immediately choosing a subprime mortgage. Borrowers need to be careful of lenders who steer them toward subprime mortgages without presenting other options.

Subprime ARMs are short-term financing vehicles designed to allow borrowers to repair or establish their credit and build equity in their homes to the point at which they can refinance into a mortgage with more favorable terms. There are several risks associated with this type of short-term borrowing, including the risks of payment shock and home equity.

Borrowers need to identify, understand and measure these risks. Borrowers also need to be aware of the prepayment penalties that many subprime ARMs carry, and a mortgage's interest rate cap structure. As a final word, borrowers should never ignore an ARM's margin; it might or might not be negotiable with a single mortgage lender, but can be a distinguishing factor between the fully indexed interest rate charged between different subprime mortgage lenders.

For a one-stop shop on subprime mortgages and the subprime meltdown, check out the Subprime Mortgages Feature.

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