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Question: I am a first time homebuyer and thought that my credit was in good shape. However, when I applied for a loan, the lender told me that I could only quality for a sub-prime loan, which would be at a higher interest rate and that I would have to pay 4 or 5 points.

Exactly what is a sub-prime loan and what should I do?

Answer: There are several things you should do, including immediately looking for another lender.

A sub-prime loan is generally made to persons who cannot qualify for a traditional mortgage. According to a recent study issued by the Federal Reserve Board, "The subprime category of residential mortgages includes loans made to borrowers that displayed one or more of the following characteristics at the time of loan origination: weakened credit histories stemming from payment delinquencies, charge-offs, judgements or bankruptcies; reduced repayment capacity as measured by credit scores or debt-to-income ratios, and incomplete credit histories." (July 2006 Senior Loan Officer Opinion Survey on Bank Lending Practices, issued August 14, 2006 by the Federal Reserve Board.)

You say that you have a decent credit rating? Have you obtained and reviewed your credit report. There are three major credit reporting companies -- Equifax, TransUnion and Experian -- and you can get a free credit report from all of these companies once a year. Go to annualcreditreport.com for additional information.

Perhaps one of these companies has listed erroneous information about you. If so, you should immediately explain this to your lender, and they may be satisfied if you send them a written explanation. You should also contact the credit reporting agency with a written statement explaining the discrepancy.

Do you have any friends or relatives who may be willing to co-sign and guarantee your loan? Can you increase your deposit so that the amount of your loan will be lower than the original application. As listed in the Federal Reserve analysis, "debt-to-ratio" is often used a justification for a sub-prime loan.

For example, if you applied for a 95 percent loan, and now are able to come up with more cash so that the loan is only 90 percent of the purchase price, the lower loan will reduce this ratio.

These are issues you should explore with your lender.

Additionally, you must talk with other lenders. The majority of sub-prime lenders are legitimate. They do serve to allow people with bad or questionable credit to be able to buy a house and join the American dream. While interest rates will be higher with a subprime loan, at least the borrowers will be able to pay a mortgage -- and get the benefits of appreciation and tax deductions -- instead of just paying rent.

There are unfortunately many disreputable lenders who just want to take advantage of consumers. These are generally referred to as "predatory lenders" and there is a clear pattern to their method of operations.

You make application for a conventional mortgage, at 6.25 percent. The lender takes your information, and a few days later calls you back to advise that you cannot qualify for that low mortgage. However, "we will give you a loan at 9.5 percent, with four points, and if you can demonstrate within one year that you have made all of the payments on a timely basis, you can refinance at regular rates."

Is this a legitimate lender or are you the subject of a "bait and switch"? The predatory lender is prepared to make a loan to you with the expectation that you will quickly go into default, in which your house will be foreclosed upon, and the lender can start all over again with another innocent consumer.

One way to determine the bona fides of that lender is to shop around. Are other lenders reluctant to make you a conventional loan? If so, stick with your original lender, but only if you carefully read the terms and conditions in your loan documents and are completely satisfied that you can make the monthly payments.

You should also contact such organizations as the Better Business Bureau, your local office of consumer protection and the Federal Trade Commission to determine the status of that lender.

The Department of Housing and Urban Development (HUD) also has a strong interest in weeding out these predators. Recently, HUD issued a commentary on subprime lending, pointing out some interesting facts about subprime lenders:

  • home refinance loans account for higher share of subprime lender's total origination than prime lenders' originations;
  • subprime lenders originate a larger percentage of their total originations in predominately black census tracts than prime lenders, and
  • subprime lenders are more likely to have terms like 'consumer,' 'finance,' and 'acceptance' in their lender names.

(HUD, Homes & Communities, March 24, 2006)

A final note of caution: I hope that you have a financing contingency in your contract, which gives you the right to terminate your contract and get your money back if you are unable to obtain financing within a certain period of time. Read that clause carefully. Since you have been rejected for a loan, and before your contingency expires, you should advise the seller (or the seller's agent) of this fact, and either formally have the contract declared null and void or get an extension on the contingency period.

If you do not take any action, you will probably lose your earnest money deposit.

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