Sub-prime lending is pretty much as it sounds: a loan provided by a financial institution or other lender to a borrower that for various reasons doesn't qualify for a "prime" mortgage.
With home prices perpetually climbing higher and with banks continuing to tighten lending standards, more and more people are being pushed into the sub-prime space when applying for a mortgage, which requires higher interest rates and often more stringent repayment terms.
Those in the financial world and certainly those who witnessed the stunning housing market collapse in the United States some six years ago are likely already familiar with the concept of a sub-prime mortgage. Back in 2006 and 2007, hundreds of thousands of lenders in the U.S. were handing out mortgages to people who under normal circumstances would not be eligible for a regular mortgage due to already high debt levels, poor credit, lack of income or other factors, yet were approved for amounts and at rates far above what they qualified for, or could afford.
With home prices across Canada continuing to march higher and with banks making it increasingly difficult to qualify for "prime" mortgages, record numbers of people are tapping the sub-prime mortgage market, raising concerns that the same thing could happen here.
Indeed, lending by Canadian non-commercial lenders -- pretty much any institution that is not a Class A bank -- has skyrocketed. According to a CIBC report published earlier this year, lending by non-commercial bank lenders has actually doubled since 2012, and was still rising at a year-over-year pace of more than 20 per cent as of the end of 2014, by some economists' estimates.
Beyond the big six banks getting more particular about who they lend to and how much, for reasons of their own or as dictated by the government, there are a lot of reasons behind the rapid rise in sub-prime lending: young people fresh into the workforce and looking to borrow a large sum of money to buy their first home or condo; people whose stated income technically doesn't allow them to borrow enough to buy a home at today's prices in the area they want; people whose credit history isn't perfect, or who already carry debt that pushes their lending ratios over the required limit; people who have changed or lost their job, or have become self-employed.
To be sure, taking on a sub-prime mortgage is not optimal. In addition to having higher interest rates, sub-prime loans often come with higher fees. What's more, sub-prime mortgages typically include lender fees that are required upon the closing of the mortgage and extremely high penalties if the mortgage is broken, making it difficult and expensive to refinance before the end of the term.
That said, borrowing through a sub-prime lender isn't necessarily a bad thing, so long as you have a plan and strategy for moving yourself towards a prime loan or mortgage with an "A" lender over the longer term:
• Read the fine print. As stated, sub-prime mortgages are typically more restrictive, not only in terms of being locked in for the duration of the loan, but also in terms of what penalties borrowers will be on the hook for if they miss a payment or need to break the mortgage. Even paying the loan off early can cost you substantial fees penalties. Know what you are getting into.
• Borrow what you can afford. Just because you qualify for a sub-prime mortgage doesn't mean you should sign on the dotted line. The typical rule of thumb is that your mortgage payment should be no more than 50 per cent of your after-tax income. Even then, it's critical to ensure you have enough financial wiggle room in the event something happens. Again, read the fine print: If part of the agreement is for your rate to re-set to a higher rate in future, make sure you can afford the increased payments.
• Have a down payment/pay it down. In today's difficult economic climate, it's tough to save for something that seemingly keeps going up in price. But the more you can put down, the less you will end up paying in interest, which over the long term will make paying off your mortgage and owning your home outright both faster and easier. And remember: sub-prime lenders want their money back just as much as you want your home. Explore what kind of pre-payment options are available and use them, or increase the amount and frequency of your payments.
• Have a plan. Key to being in a sub-prime mortgage is having a plan to eventually get out of it. Ensure the duration of the loan is short enough and the payments manageable enough that you can strengthen your credit and build up equity. Pay as much in principal as you can; make bi-weekly rather than monthly payments, this will help pay down the balance as you would be making an additional two payments per year.
Be it sub-prime, prime or even a combination of the two, there are many options when it comes to structuring your mortgage in a way that sets you up for success in paying down what will be one of the biggest investments of your life. Talking through your options with your mortgage broker and having a realistic strategy in place is key to ensuring a long-term plan that works for you, allows you to build equity, and, of course, enjoy your home.
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