As noted in a 2007 Federal Reserve publication, What is Subprime Lending?, “a precise characterization of subprime lending is elusive.” In fact, the specific meaning of subprime lending has been the source of considerable debate among regulators, legislators, lenders, and advocates for low-income communities.
Webster’s dictionary defines subprime as “having or being an interest rate that is higher than a prime rate and is extended especially to low-income borrowers.” According to former Federal Reserve Governor Edward M. Gramlich, “Subprime lending can be defined simply as lending that involves elevated credit risk.”
Subprime loans should be for people whose credit scores prevent them from getting access to a regular — or prime — loan. Borrowers with low credit scores can still get a mortgage, but they will have to pay a higher interest rate, and often higher fees. That’s because the credit score reflects the borrower’s debt history. If a borrower has a track record of not paying back loans, the lender will quite reasonably think he or she is a riskier bet than someone with a good track record, and will charge more for the loan, hedging against default.
In this project, the Center for Public Integrity used a definition employed by the Federal Reserve Bank to capture most subprime loans reported to the government. For that purpose, subprime loans are those at 3 percentage points or more above the rate of comparable U.S. Treasury securities. For more on the Center’s criteria, please see this project’s Methodology page.
Definitions vary, but a 2000 joint report from the U.S. Department of Housing and Urban Development and the Treasury Department described predatory lending as “engaging in deception or fraud, manipulating the borrower through aggressive sales tactics, or taking unfair advantage of a borrower’s lack of understanding about loan terms.” The report noted that the practice “generally occurs in the subprime market.”
The report found four main categories of “too-frequent abuses” in the subprime lending market. These were loan flipping, excessive fees, and “packing,” lending without regard for the borrower’s ability to repay, and outright fraud and abuses. Other tactics may include making unaffordable loans, balloon payments, and high prepayment penalties.
Making unaffordable loans
Lending without regard for the borrower’s ability to repay is the most basic form of abusive lending. “Some predatory mortgage lenders purposely structure loans with monthly payments that they know the borrower cannot afford,” wrote Atlanta Legal Aid attorney William Brennan, “so that when the homeowner is led inevitably to the point of default, she will return to the lender to refinance the loan, and the lender can impose additional points and fees.”
Overcharging on rates, points, and fees
Interest rates on subprime loans were typically 2 to 3 percentage points higher than on prime loans. While that higher rate may be appropriate for borrowers with blemished credit, some subprime borrowers could have qualified for prime loans with lower rates. In prime loans, a borrower might pay discount points in exchange for a lower interest rate. In abusive subprime lending, borrowers were charged points but were not given a lower rate in exchange. Those points were then financed into the loan itself rather than paid through cash up front, adding to the total loan amount.
Mortgage broker fees and kickbacks
Many subprime lenders relied heavily on brokers to sell their loans. Lenders sometimes paid kickbacks to brokers for bringing in borrowers, including fees if the borrower took out a loan at an interest rate higher than the rate they qualified for. The difference between the rate the borrower could have gotten and the rate she paid would be passed on to the broker, a fee known as the yield spread premium. Borrowers often thought the broker was working to find them the best deal — but in a predatory loan, he was working to get himself the biggest possible fee, regardless of the costs to the borrower.
Abusive subprime lenders would add credit insurance to almost every loan, usually without telling the borrower, as described by John Dough, an anonymous broker who testified at a 1998 Senate hearing.
Flipping was a shorthand term describing repeated refinancings. Each refinancing would include closing costs, brokers’ fees, credit insurance, and other expensive products, which would strip equity from the home.
Some subprime loans featured so-called balloon payments several years into the loan. Borrowers would pay a relatively low monthly fee for a specific period — as short as a few years — but then have to come up with a lump-sum payment for the balance of the mortgage. If they were unable to cover the big payment, the lender would refinance the loan, adding a new round of closing costs, brokers’ fees, and credit insurance.
High prepayment penalties
In some abusive subprime loans, borrowers would have to pay a fee to the lender if they paid off the loan early. So, if borrowers realized they were getting gouged by a high-rate loan, and found another, more affordable mortgage, they would be forced to pay the original lender in order to refinance at the lower rate.
Mandatory arbitration clauses
Some abusive loans featured mandatory arbitration clauses, which prevented borrowers from seeking redress in court if they felt the loan terms were abusive — or for any other reason, for that matter. While these clauses denied borrowers access to the judicial process, the lenders did not have to arbitrate claims against borrowers, and could initiate foreclosure proceedings if a borrower defaulted on the loan without engaging in arbitration first.