It's 'buyer beware' on subprime loans

Dana Dratch, September 22, 2006

Remember when you're shopping for a subprime loan, it doesn't mean lenders don't want your business. Just the opposite, actually, but it does mean you'll pay more for the money you borrow -- all the more reason to shop carefully.

"Often buyers aren't doing the shopping," says Allen Fishbein, director of housing and credit policy for the Consumer Federation of America. "A borrower needs to step back at this point and say, 'I've gotten this offer. Let me get some independent advice and maybe get a few more offers before I decide.'"

The need to shop and compare "is even more important for the subprime borrower," he says.

The gray area
First, are you certain you're subprime? The credit score used to separate prime from subprime varies with the lender and loan.

"Typically, usually below 600, it's safe to say is always subprime," says Barry Paperno, manager of customer service for Fair Isaac Corp., which designed the FICO score. "From 600 to 650 is kind of a gray area, depending on the lender."

A good rule of thumb is that the cutoff will be a FICO score around 620, says Fishbein.

"It's not standard," he says.

Two lenders looking at the same customer could rank him differently. "It's just not as uniform a standard as many borrowers think," says Fishbein. "This has created some confusion in the marketplace."

That means you don't take the first loan you're offered, especially if the rates are subprime. "Anybody in the mid-600 range, credit score-wise, should be very, very careful," says Robert Manning, finance professor at the Rochester Institute of Technology and author of "Credit Card Nation," "particularly if it's an unsolicited loan."

Instead, recognize that you're a commodity.

"Often people feel like they're not desirable as a customer and are happy if anybody wants to work with them," says Fritz Elmendorf, vice president of communications for the Consumer Bankers Association, a financial services trade group.

If you're on the edge, you can do a couple of things. First, be careful where you shop.

Try credit unions and banks that make both prime and subprime loans, says Ira Rheingold, executive director of the National Association of Consumer Advocates. If you're mortgage shopping, try some of the Internet sites that let you shop a variety of lenders simultaneously.

Some lenders are subprime, says Rheingold. "If you walk in and are eligible for prime, they may not be able to provide it to you."

Second, do all those things that will boost your scores a few points. Pay off balances (as much as you can). Keep making on-time payments. If you know you need a home or car loan, don't apply for other forms of credit, such as credit cards, even those preapproved offers or store cards. Inquiries can reduce your score as much as 10 percent, which is a lot if you're on the line between subprime and prime. When you do start shopping for your big loan, keep all your applications within a 14-day period so that the entire process is certain to be counted as one inquiry by the credit bureaus.

"A modest amount, 20 to 30 points, could reduce how much they are charged," says Fishbein.

Third, pull your report and make sure your score reflects your true credit history. "A lot of times people fall into subprime category because information on their credit report is not correct and is depressing their credit scores," says Norma Garcia, a senior attorney for Consumers Union. "Make sure it's consistent and accurate."

Full steam ahead
If waiting to boost your score is impractical and everyone seems to see you as subprime, then you want to shop carefully. Some lenders will treat you the same as a prime customer. Others will assume that if your credit is blemished, you aren't good at managing money and may not read the fine print. And some will assume that if you're not good with money, you're a bigger risk for them.

But if you're getting a subprime loan, it's even more important to read the fine print. If you've had money trouble in the past, you want to be extra careful not to sign anything that will cause more problems.

Subprime borrowers expect to pay higher APRs, so it pays to compare. In addition, it's the terms that make the loan subprime, not the lending institution, so don't let the name on the door fool you.

"Just because you have a traditional or prime loan from a lender doesn't mean you can't get a subprime product from the same lender," says Manning. "People tend to get lulled into complacency that they won't get ripped off."

You also need to look out for something that sounds too perfect. "If an offer sounds too good to be true, it is," says Manning. "If you know that you're getting 22 percent rates on credit cards, and all of a sudden you're getting a zero-percent credit card, run. It means you're going to be getting a lot of fees."

If you're shopping for a home or auto loan, ask about any and all fees upfront. If there seem to be a number of them, that's not a good sign. Your credit score means the lender could have a slightly higher risk in making the loan. But the cost of filling out the paperwork shouldn't change. Shop around.

Limit your risk
Lenders are all about limiting their risks. You've got to do the same. Terms that may be benign for prime borrowers can sound the financial death knell for some subprime customers.

Avoid balloon payments and prepayment penalties. Balloons set up a financial crisis. If you can't make the cash, you're out of luck.

Prepayment penalties punish you for improving your finances. If you take a subprime now, but your situation is improving and in two years you will qualify for prime, you have to pay the penalty to your old lender.

For subprime borrowers, these clauses can often become more than paperwork details.

Balloon payments increase the likelihood of default by 46 percent, according to Michael Stegman, professor of public policy and director of the Center for Community Capitalism at the University of North Carolina at Chapel Hill, who conducted a recent study of subprime mortgage refinance loans. Prepayment penalties will raise the odds of defaulting by 15 percent to 20 percent, depending on the terms.

But what tends to hurt subprime borrowers who refinance the most? Adjustable-rate mortgages, says Stegman. In his study, adjustable-rate refinance borrowers had a 49 percent greater chance of losing the home in foreclosure.

Don't be afraid to ask, "What's in this for me?" If the answer is just "the loan," that's not good enough. In the prime market, an ARM comes with a lower rate. But in subprime lending, "the benefits are not all that clear," says Stegman. If you're considering accepting unfavorable terms like an adjustable rate, balloon payment or prepayment penalty, what's the trade-off?

Cover your assets
If your credit is bad, you might find plenty of lenders who are willing to help you if you put up collateral. But unless it's a first mortgage or a car loan, where the asset being bought backs the loan, this can be a trap.

"Don't risk a valuable asset for a small loan," says Jean Ann Fox, director of consumer protection for the Consumer Federation of America. "People are betting the entire value of what they paid for a car when they get a car title loan." With payday lending, you're putting your bank account at risk. If you can't pay, some lenders will just keep cashing your initial check, piling up the bounced-check fees and putting your account and check-writing privileges in jeopardy, says Fox.

And ask about penalties. What happens if a payment is late or you miss a payment? Can they hike your rate, and if so, by how much? Are there fees? How much are they? If the terms on two loans are similar, it could make the difference.

A few areas where it pays to be cautious:

Want to make the smart move? Be sure to study the big picture: the overall cost of borrowing the money, says Fox. When you look at all the charges and fees, what will it actually cost you, in total, to borrow the money?

"It takes work," says Fox, but "see if it isn't worth your time to get the best deal you can."

Dana Dratch is a freelance writer based in Atlanta.


This story ran on on September 22, 2006.