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The return of subprime lending?

By   |  Posted in First-Time Homebuyers

In the wake of the housing bust, few lenders had much appetite for risk, offering primarily "plain vanilla" mortgages to highly qualified borrowers. However, Keith Gumbinger, vice president of HSH.com, says that now, though, there's a "huge cohort of wannabe borrowers that lenders will have to look at in order to grow their business."

Sam Garcia, founder and publisher of Mortgage Daily in Dallas, agrees, saying now that refinancing has slowed, lenders will need to be less conservative in order to generate more business.

That doesn't suggest that "liar loans" will return to the market, says Gumbinger, but some mortgage programs -- such as interest-only loans -- will become more available but with more restrictions in place to minimize risk.

"Those mortgage loans were niche products to begin with and were intended for 2 percent of the market," says Gumbinger. "Unfortunately they were marketed to 20 percent of the market and that's when the problems started."

Garcia says that subprime loans used to require down payments of 5 to 20 percent depending on the borrower's credit and had higher interest rates.

"The problem was that risk-layering exploded, with down payments dropping to zero for borrowers who had bad credit and couldn't necessarily verify income," says Garcia.

Return of subprime lending

Gumbinger says that while there's a lot of uncertainty in the mortgage industry over the final definition of a "qualified residential mortgage" (QRM) and what will happen to Fannie Mae and Freddie Mac, he believes mortgage products will have to expand.

"It won't be unfettered and there will be restrictions, but frankly, subprime lending will have to come back," he says.

Garcia says subprime lending will come back in a form with more accountability than in the past, but Steve Cohen, vice president and loan originator with First Place Bank in Rockville, Md., believes that the subprime market is gone forever.

"We're backing away from the idea that everyone can buy a house," says Cohen. "The idea is not to let people decide what's affordable, but to let banks decide."

Disappearing mortgage products?

Here are five mortgage products which largely disappeared after the downturn. Some are gone for good, others are making a comeback.

No. 1: Option ARMs

"The only loan product that disappeared entirely and isn't likely to come back is option ARMs," says Gumbinger. "It was intended for an environment with rising home prices to ameliorate the risk and it was initially meant for people who had a good handle on their finances. The problem was they gave too much flexibility to too many borrowers."

No. 2: Interest-only loans

Garcia says interest-only loans won't be considered a QRM, which means they're likely to have numerous restrictions and will require a large down payment, but he believes they'll be available.

Gumbinger says some interest-only loans are available now, especially for jumbo loans, but only for borrowers with a strong balance sheet and proof of substantial future income.

"They're not necessarily risky if you can manage the payments when they rise," he says.

No. 3: Balloon-payment loans

While rare today, loans with balloon payments may be reintroduced at some point, Cohen says, particularly for second loans that are amortized over 30 years but require a balloon payment after 15 years.

No. 4: No/low-documentation loans

Gumbinger says loans with limited documentation are coming back to give flexibility to some self-employed individuals, but they require a bigger down payment and excellent credit.

An alternative to no-documentation loans for high-net-worth individuals is a loan based on their proven assets rather than an income stream.

"Asset-based loans need to come back for people who have excellent credit and extremely high levels of assets but don't show enough income for a traditional loan," says Cohen.

No. 5: Zero-down-payment loans

Some mortgage lenders have already brought back 100 percent financing, but this time the borrowers must have good credit and verified income to prove they can afford the payments, says Garcia. These loans typically require mortgage insurance and/or a higher interest rate to compensate for the added risk to the lender.

"Mortgage lending has already contracted so much that it needs to expand over time," says Garcia. "But even if some of these loan products come back, the CFPB rules will prevent lenders from allowing loans to be as risky as they were in the past. They'll have to verify income and have to check credit, and subprime loans will require at least 20 percent down."

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