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A loan that is offered at a rate above prime to individuals who do not qualify for prime rate loans.

Subprime loans tend to have a rate that is 0.1% to 0.6% higher than the prime rate. Although the additional percentage may seem small, for mortgages and other large loans, this translates to thousands of dollars worth of additional interest payments.

Subprime loans cost a lot,
but they can help mend credit history

By Michael D. Larson

It may have been a couple late payments or something as bad as a bankruptcy, but whatever the problem, the outcome is the same: A scarlet letter on the credit report and an "Application Denied" stamp from the mortgage lender.

The bad-credit problem traps plenty of people, but a booming business among so-called "subprime" lenders means money likely will be available to those looking to move into a new home or refinance to consolidate debt.

Think about it
But experts caution people to carefully weigh the benefits and drawbacks of taking out a subprime loan. Just having one and handling it well can help repair a damaged credit history, but they cost thousands more in interest than standard mortgages.

"I think, in many terms, of my own kids," says Daniel Rich, chief financial officer of Parsippany, N.J.-based Champion Mortgage Corp. KeyCorp of Cleveland bought Champion in September, 1997, to expand its subprime lending. "I would tell them, 'if you can, wait and save money and not borrow for a few years, there's nothing wrong with that.' That's kind of how my father taught me."

Subprime lending, by its very nature, places lenders at risk. When all is said and done, that means banks and other players charge higher rates for subprime loans to compensate for potential losses from customers who may run into trouble or default. Subprime loans also cost more because they are considered "non-conforming," or not up to the standards of Fannie Mae and Freddie Mac. Those two quasi-governmental agencies buy traditional, "conforming" mortgages from lenders, repackage them and sell them to Wall Street investment firms as securities.

Track record counts
Borrowers can fall into the subprime category for any number of reasons, and assessing how risky a customer can be a difficult thing for lenders. The process relies less on the computerized credit scoring methods widely favored by traditional lenders and more on a borrower's debt payment track record, according to subprime experts. In the end, customers get stamped with a grade-school-like ranking: A for those with the best credit, B, C or D for those with progressively worse histories. An E can show up as well, but is extremely rare.

"We don't, as a rule, say we want a score of this or you're out. We have our own underwriting guidelines," says Mary Chiappetta, vice president of marketing in the home equity lending group of Amresco Inc. The Dallas-based company originates and services residential and commercial mortgages, offering loans to people with A to D credit.

One question, two answers
Where someone falls on the scale depends on a number of things. And two lenders may look at the same borrower and arrive at two different credit grades because the categories aren't set in stone.

"A-minus is as simple as one time being 30 days late on the mortgage, but otherwise good," Chiappetta says. "D could be bankruptcy or foreclosure."

Adds Rich: "If you have a consistent pattern of late payments across the board, you're going to be considered a B/C borrower."

"An E category means most of us in top management know your name," Rich says. "We have instances where no way would we make this loan except" for unusual cases. He recalls one Champion customer who got a loan despite a poor credit history because she didn't have money to pay the funeral home where her husband's body was waiting for burial.

A borrower's credit grade determines a number of factors, including what rate the loan will carry and how much of a home's value will be loaned. On a 30-year fixed mortgage, for instance, an Amresco borrower just shy of an A rating would be able to borrow 90 percent of a new home's value at a rate of 11.5 percent, Chiappetta says. Someone with D credit could borrow about 65 percent of the value at 13.4 percent.

On a refinance loan, rather than a purchase, Champion's Rich says a customer with D credit could expect a rate of 12 percent to 12.9 percent. Those at the top of the heap likely would see a rate of about 8 percent.

Who is a candidate?
So, if that's how the subprime process works and those are the rates, who should consider borrowing?

The advice is mixed, but generally speaking, someone whose monthly obligations are swallowing too much of the weekly paycheck might benefit from refinancing the mortgage at a subprime rate and taking out cash in the process to pay off debts. The cost over the loan's lifetime will rise, but the tax-deductibility of mortgage interest makes it cheaper than the interest charged on most credit cards, auto loans and the like.

And subprime loans can help renters become homeowners. While the rate charged will be high, a one- or two-year history of on-time mortgage payments will help demonstrate creditworthiness, Chiappetta says. That, in turn, could mean a less expensive refinancing down the road, assuming rates don't spike.

"You can stay in an apartment and write a check every month and not have any kind of tax advantage, or you can go out and get a mortgage loan at 10 percent," Chiappetta says. "We always say, 'Why wait?' "

Still, experts caution that getting a subprime loan means much greater interest costs over time. A 30-year fixed loan for $100,000 at Amresco's 11.5 percent rate, for instance, would have monthly payments of $990 and total interest of $256,505. With the 6.66 percent national average found by a recent survey, the same loan would require payments of just $643 and cost $131,346 in total interest -- about half as much.

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