One of the leading causes of the mortgage meltdown and rising foreclosures in the state of Washington is subprime lending and the unscrupulous lenders who fraudulently prey on unwary borrowers.

Below is a short overview of subprime and predatory lending.

 What is Subprime lending?

Subprime lending is the practice of lenders making loans to individuals with less-than-stellar credit histories or those who are unable to verify income or who otherwise are not eligible to obtain conventional mortgage financing.

A subprime loan may also be utilized by individuals who maintain high debt-to-income ratios.

Recent figures suggest that subprime loans account for 15-20% of all home loans in the United States. The primary purpose of 50% of subprime mortgages made as a first mortgage and 75% of second lien subprime mortgages is debt consolidation and/or general consumer credit such as credit card, student loan or automobile loan repayment.

Standard and Poor's (S&P) has stated that subprime mortgages totaled $421 billion in 2006 alone. In addition, the Mortgage Bankers Association reports that all mortgage loan originations totaled $2.5 trillion.

Therefore, if these numbers are accurate then 16.8 percent of all mortgages made in 2006 were subprime loans.

However, because subprime loans are usually smaller in terms of the dollar amount of the loan, the actual percentage of money lent by subprime lenders is much higher than the 16.8%.

Several factors have contributed to the rapid rise in subprime lending. Among such factors include:

  A dramatic rise in consumer credit problems, including high interest credit cards and the unprecedented number of consumer bankruptcy filings

  The Tax Reform Act of 1986 which eliminated an individual's ability to deduct consumer credit interest payments

  The secondary mortgage market in which investors flooded the mortgage-backed securities market

  The access to mortgage loans to those who were previously unable to obtain mortgage financing

  The entrance of prime lenders and Wall Street investment firms into the subprime mortgage market which created increased competition among subprime lenders.

While there is no standardized definition of a subprime borrower, a common characteristic of a subprime loan is a loan made to a borrower who has a credit score of less than 620.

But some lenders count loans as subprime even if the borrowers have credit scores of 660 or higher, if the borrower makes a down payment of less than 5 percent or does not document income or assets. Other lenders might count those loans as Alt-A which may also be considered subprime.

Because a subprime loan carries a significantly higher risk of default, the lender will charge a higher interest rate than offered in a conventional home loan. A subprime loan can be utilized by a borrower to either purchase a home or refinance an existing mortgage.

Generally speaking, subprime borrowers will display one or more of the following characteristics:

  Two or more loan payments paid past 60 days due in the last 12 months, or one or more loan payments paid past 90 days due the last 36 months;

  Judgment, foreclosure, repossession, or non-payment of a loan in the prior 48 months;

  Bankruptcy in the last 10 years;

  Relatively high default probability as evidenced by, for example, a credit bureau risk score (FICO) of 620 or below (depending on the product/collateral), or other bureau or proprietary scores with an equivalent default probability likelihood.

Example: Assume a home was purchased 5 years ago for $200,000, and the homeowner paid 20% down ($40,000) and obtained a home mortgage loan for the remaining purchase price ($160,000). Assume further that the home had appreciated in value from $200,000 to $300,000. However, during the period of home ownership, the homeowner incurred significant credit card debt.

As a result, the homeowner's credit score slipped to 605. To repay the credit card debt, the homeowner decided to refinance the mortgage loan. Because the credit score was below 620 the homeowner's only option was to obtain a subprime loan at a significantly higher interest rate.

The new mortgage payment will be significantly higher which oftentimes results in the borrower's default or foreclosure if the borrower's income is insufficient to make the monthly mortgage payments.

 What is Predatory Lending?

Predatory lending involves engaging in deception or fraud, manipulating a borrower in a home loan transaction through aggressive sales tactics, or taking unfair advantage of a borrower's lack of understanding of the loan terms that comprise a home purchase loan or refinance transaction.

Such practices are usually accompanied with loan terms that are unfair or abusive to borrowers.

Most predatory lending cases occur in the subprime mortgage loan market where borrowers are more susceptible to abusive loan practices.

Unlike a conventional loan made by a bank or other lending institution governed by strict federal guidelines, the subprime mortgage market is fraught with smaller, unregulated lenders who aggressively compete for borrowers.

Predatory lending can take the form of various unscrupulous practices by mortgage lenders, such as:

1. Loan Flipping.

Loan flipping is the practice of repeatedly refinancing a mortgage loan without benefit to the borrower. In a loan flipping scenario, a mortgage originator such as a loan officer or broker will advise the borrower to refinance several times in order for the loan originator to earn substantial loan origination, closing costs, prepayment penalties and other fees while stripping the borrower of his or her valuable equity.

2. Packing.

Packing is the process of a loan originator including excessive fees and costs into the loan amount to be financed by the lender without the borrower's knowledge, consent or understanding.

3. Lending to unfit borrowers.

Lending to unfit borrowers usually involves a lender loaning money to a borrower who has substantial equity in the home but who is unable to make the monthly mortgage payments. This predatory lending practice is most often targeted at the elderly or others on fixed incomes and usually robs the borrower of his or her equity when the lender is forced to foreclose after the borrower's default.

4. Fraud.

Fraud can include a litany of loan practices such as the altering of loan documents without the borrower's authority or material misrepresentations or deceptive/misleading sales tactics undertaken by the loan originator in connection with a home mortgage loan transaction.

 What laws protect borrowers from predatory lending?

1. Truth in Lending Act:

The Truth-in-Lending Act (TILA) is a series of federal laws that require various disclosures to be made by a mortgage lender in connection with a residential home mortgage loan.

Specifically, the TILA requires the lender disclose various loan terms such as the finance charge, the Annual Percentage Rate (APR), and the total amount to be paid by the borrower over the course of the loan.

Penalties for violating the TILA include the ability of the borrower to cancel, or rescind the home loan and for damages incurred by the homeowner as a result of the TILA violation(s).

The borrower may rescind the loan transaction within three days of the later of:

1. closing,
2. the provision of accurate disclosures by the lender, or
3. the receipt of the right to rescind by the lender.

Additionally, the borrower can recover statutory damages equal to twice the finance charge (not greater than $2000 but not less than $200) as well as attorney's fees and costs incurred to bring the lawsuit.

2. Home Ownership and Equity Protection Act:

In certain high-cost refinance transactions the Home Ownership and Equity Protection Act (HOEPA) requires additional disclosures not required under the TILA and restricts certain loan provisions such as prepayment penalties, balloon payments and negative amortization.

Additionally, HOEPA prohibits a lender from lending solely based on the value of the borrower's property without regard to the borrower's ability to repay the loan. However, HOEPA covers only a small number of subprime loans.

The HOEPA governs loans refinance loans or home equity loans that charge either:

1. An APR of more than 10% above the yield on Treasury securities (The Federal Reserve Board may adjust this down to 8% or up to 12%) or

2. Points and fees that exceed the greater of 8% of the loan amount or $400 ($528 in 2006). The HOEPA disclosures must be made by the lender to the borrower no later than 3 days prior to closing.

Penalties for violating the HOEPA include the ability of the borrower to cancel, or rescind the home loan and to sue the lender for damages incurred by the homeowner as a result of the TILA violation(s). The borrower may also recover all finance charges and fees paid by the borrower

3. Real Estate Settlement Procedures Act:

The Real Estate Settlement Procedures Act (RESPA) requires the disclosure of settlement costs to consumers of federally-related mortgage loans at the time the borrower applies for the mortgage loan and again at closing.

The RESPA prohibits referral and other unearned fees, limits the amounts that can be withheld in a borrower's escrow account, and requires that certain relationships by and among real estate service providers be disclosed by the provider to the borrower/homeowner.

The RESPA requires lenders to provide a Good Faith Estimate (GFE) to borrowers within three (3) days of the borrower submitting a loan application. The GFE must include an estimate of the loan origination fees, third party charges such as escrow, appraisal and title insurance fees, and the amount of money that will be held for property taxes and insurance in the borrower's escrow account.

At or before closing, lenders must provide borrowers with a second settlement statement (called a HUD-1) that sets forth the actual costs of the items set forth in the good faith estimate.

The figures in the HUD-1 must reflect a reasonable relationship to the estimates set forth in the GFE.

 More Information

For more information on subprime and predatory lending, please don't hesitate to contact us. We can be reached by phone at: (206) 442-9500 (Toll-free: 1-800-206-6122).

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