What Is a Subprime Mortgage and Who Is a Subprime Borrower

How Do Regulators Characterize Subprime Borrowers?

By providing loans to borrowers who do not meet the credit standards for borrowers in the prime market, subprime lending can and does serve a critical role in the nation's economy. These borrowers may have blemishes in their credit record, insufficient credit history or non-traditional credit sources. Through the subprime market, they can buy a new home, improve their existing home, or refinance their mortgage to increase their cash on hand.

"Unequal Burden: Income and Racial Disparities in Subprime Lending in America"

U.S. Department of Housing and Urban Development April 2000

Subprime borrowers typically have weakened credit histories that include payment delinquencies, and possibly more severe problems such as charge-offs, judgments, and bankruptcies. The borrowers may also display reduced repayment capacity as measured by credit scores, debt-to-income ratios, or other criteria that may encompass borrowers with incomplete credit histories. OCC, FRB, FDIC, and OTS Federal Register July 12, 2002

The term subprime generally refers to borrowers who do not qualify for prime interest rates because they exhibit one or more of the following characteristics: weakened credit histories typically characterized by payment delinquencies, previous charge-offs, judgments, or bankruptcies; low credit scores; high debt-burden ratios; or high loan-to-value ratios.

Roger T. Cole, Director, Division of Banking Supervision and Regulation

Board of Governors of the Federal Reserve System March 22, 2007

Given the intense media coverage of the subprime mortgage market, it may come as a surprise to learn that the distinction between prime and subprime borrowers is not clear-cut. Economists at the Federal Reserve Bank at San Francisco define subprime as "a lender-given designation for borrowers with low credit scores (FICO scores less than 620, for example), with little credit history, or with other types of observable credit impairment."1 But it is misleading to think that lenders rely solely on FICO scores for distinguishing between the two types of borrowers. Individuals can be considered prime borrowers with FICO scores below 620, and they can be considered subprime borrowers with scores above that cutoff.

A FICO score can range from a low of 300 to a high of 850.2 Higher scores represent greater creditworthiness; the median score is about 720. And while we tend to treat FICO scores as an appropriate measure of a borrower's creditworthiness, Figure 3.1 shows that roughly one-fifth of the population would be in the subprime borrower category based on a cutoff of 620 alone—meaning that, conversely, four-fifths of the population would be considered prime borrowers. The fact that such an enormous portion of the population would classified in the prime

Figure 3.1 National FICO Scores Display Wide Distribution

Percentage of population

Source: myFICO (2007).

Note: FICO scores range from 300 to 850.

Figure 3.1 National FICO Scores Display Wide Distribution

Percentage of population

Fico Scores Percent Population

Source: myFICO (2007).

Note: FICO scores range from 300 to 850.

up to 499 500-549 550-599 600-649 650-699 700-779 750-799 800+

up to 499 500-549 550-599 600-649 650-699 700-779 750-799 800+

Figure 3.2 What Goes into a FICO Score?

Types of credit in use 10%

New credit 10%

Length of credit history

Figure 3.2 What Goes into a FICO Score?

Types of credit in use 10%

New credit 10%

Length of credit history

Payment history 35%

Amounts owed 30%

Payment history 35%

Amounts owed 30%

Source: myFICO (2007).

borrower category on the basis of just their FICO scores may not be fully appreciated in the constant bombardment of news stories about problems in the mortgage market.

Figure 3.2 illustrates the components that make up a FICO score. Although a score captures a great deal of useful information, it clearly omits certain factors that could be critical to lenders in making credit decisions—most notably salary and employment history. Lenders may also consider criteria such as the loan-to-value ratio (whether the borrower is able to contribute a significant down payment) and the income-to-debt ratio (whether the borrower can reasonably be expected to handle the required monthly loan payments given their income). Figure 3.3 shows the distribution of prime and subprime borrowers by FICO score. It is interesting to note that prime borrowers may have FICO scores below 400, while subprime borrowers may score above 820.

Figure 3.3 shows that 55 percent of the borrowers who received mortgage loans in 2006 had FICO scores above 620 yet were considered subprime by lenders. Indeed, most importantly, there is no standard industrywide definition for a subprime borrower. This means each lender makes its own determination about which customers are subprime.3 To the extent that appropriate risk-based pricing (setting higher interest rates for borrowers deemed to be riskier) was used, moreover, the

Figure 3.3 Prime and Subprime Mortgage Originations by Borrower FICO

Score Reveal Substantial Overlaps (2006)

Percentage of total originations 20

FICO above 620

Prime: 93% Subprime: 55%

Percentage of total originations 20

FICO above 620

Prime: 93% Subprime: 55%

National Distribution Fico Scores

<v* «JP oSs <Ss a<% o» Ois oSs <Ss o» Ois a i? i»

FICO score

<v* «JP oSs <Ss a<% o» Ois oSs <Ss o» Ois a i? i»

FICO score

Sources: LoanPerformance, Milken Institute.

distinction between prime and subprime lending becomes somewhat artificial.

Just as prime and subprime borrowers cannot be distinguished on the basis of FICO scores alone, it is similarly misguided to categorize them based on the mortgage products they choose. Over the past decade, most (if not all) of the products offered to subprime borrowers have also been offered to prime borrowers. In fact, from January 1999 through July 2007, prime borrowers chose 31 of the 32 types of available mortgage products (including fixed-rate, adjustable-rate, and hybrid mortgages, including those with balloon payments) chosen by subprime borrowers. (See Appendix Tables A.18 and A.19 for an exact breakdown.)

There are clear differences in the extent to which certain types of loans were chosen by prime and subprime borrowers, but both groups have had access to a wide range of mortgage products. Some of the products criticized for being inappropriate have not been marketed to or chosen by subprime borrowers exclusively. Furthermore, regulatory authorities have noted that "subprime lending is not synonymous with predatory lending."4

If the product itself, such as the adjustable-rate mortgage, was the problem in the subprime market, one might expect all borrowers using that product to be facing foreclosure. But this is not the case. Foreclosure rates are rising, but the rates differ widely by type of product and borrower. No single product accounts for all foreclosures, though certain loans (such as hybrid mortgages and pay-option ARMs, which will be addressed later) posed greater problems than other types of mortgage products.

Rather than barring the use of a certain product by all borrowers, it is important to question whether individuals are being matched with the appropriate products for their financial circumstances. An adjustable-rate mortgage with a low initial teaser rate may be a wonderful tool for a medical student who expects her income to grow substantially in the near future, for example, but it may not be the best choice for borrowers who lack similar prospects—and it is definitely a poor choice for any borrower who does not fully understand how the payments may change over time. Mortgage products with perfectly legitimate uses should not be used in ways for which they were not designed.

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