In order to tap the increasing sub-prime market, lenders took on a lot of risk accompanied with poor credit ratings. To offset the risks, lenders demanded a higher interest rate or other credit enhancements to compensate the increased costs associated with collection from such borrowers, as well as the probable default rate.
Sub-prime loans can offer an opportunity for borrowers with a less-than-ideal credit record to become a home owner. Borrowers may use this credit to purchase homes, purchasing a car, meeting living expenses, or even closing overdue on a high interest credit card. But due to low profile credit of borrower, it is only available at higher interest rates. But there is an avenue provided by sub-prime lending which is a method of repairing credit; in case of good track record, the borrower would be able to refinance again onto normal rates after a certain period of time.
Normally, the kind of credit profile that disqualifies a borrower for a prime loan may be one or more of the following:
- Two or more loan payments paid after they were overdue for 30 days in last 1 year, or one or more loan payments paid after they were overdue for 90 days in the last 3 years;
- Foreclosure, repossession, or non-payment of a loan in the past;
- Bankruptcy within the previous 7 years;
- High default probability
FNMA prime loans go to borrowers with
- a credit score above 620 (credit scores are between 350 and 850 with a median in the U.S. of 678 and a mean of 723),
- a debt-to-income ratio no greater than 45% (meaning that no more than 45% of gross income pays for housing and other debt), and
- a combined loan-to-value ratio of 90% (meaning that the borrower is paying a 10% down payment).