As Subprime Mortgages Increase, Lenders Increase Prepayment Penalties and Down Payments: St. Louis Fed Analysis

ST. LOUIS — As the market for subprime mortgages has expanded rapidly in the past decade, much of the expansion has been in the least-risky segment of the market. At the same time, lenders of subprime loans have increased their use of prepayment penalties and large down payments to offset losses from defaults.

Those facts emerge from an analysis by economists Souphala Chomsisengphet and Anthony Pennington-Cross, who looked at the evolution of the subprime mortgage market for the January/February issue of Review, the Federal Reserve Bank of St. Louis' bimonthly journal of economic and business issues. The publication is also available on the Reserve Bank's web site: https://research.stlouisfed.org/publications/review/ .

Subprime lending is a relatively new and rapidly growing segment of the mortgage market that expands the pool of credit to borrowers who, for a variety of reasons, would otherwise be denied credit. For example, some borrowers who would probably fail a credit history requirement in the standard (i.e., prime) mortgage market have a better opportunity to get credit in the subprime market.

Two potential benefits associated with subprime loans are an increased number of homeowners and the opportunity for those homeowners to create wealth.

"Because of its complicated nature, subprime lending is simultaneously viewed as having great promiseand great peril," say Chomsisengphet and Pennington-Cross.

Their analysis indicates that while the subprime market has grown substantially, that growth has not been smooth. The market expanded rapidly until 1998, then suffered a period of retrenchment. Now, it is expanding rapidly again, especially in the least-risky segment of the market.

Chomsisengphet and Pennington-Cross found that since 2000, the focus of the subprime market has shifted by providing loans to borrowers with higher credit scores, allowing larger loan amounts, and lowering the down payments for fixed-rate mortgages.

They also note, however, that the use of prepayment penalties has declined in the last few years because "the securities market has adjusted to public concern about predatory lending and the regulation of finance companies has changed."

In addition, their research shows that the subprime market has provided a substantial amount of "risk-based pricing" in the mortgage market by varying the interest rate of a loan based on the borrower's credit history and down payment. In general, Chomsisengphet and Pennington-Cross found that lenders of subprime loans typically require larger down payments to compensate for the higher risk of lower-grade loans.

Even with these compensating factors, however, Chomsisengphet and Pennington-Cross conclude that borrowers with low credit scores still pay the largest premiums.

With branches in Little Rock, Louisville and Memphis, the Federal Reserve Bank of St. Louis serves the Eighth Federal Reserve District, which includes all of Arkansas, eastern Missouri, southern Indiana, southern Illinois, western Kentucky, western Tennessee and northern Mississippi. The St. Louis Fed is one of 12 regional Reserve banks that, along with the Board of Governors in Washington, D.C., comprise the Federal Reserve System. As the nation's central bank, the Federal Reserve System formulates U.S. monetary policy, regulates state-chartered member banks and bank holding companies, and provides payment services to financial institutions and the U.S. government.

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