Residential loans taken out by people with low credit scores are known as high-risk mortgages. Lenders believe that people with past credit problems are more likely to default on mortgages than borrowers with good credit. When borrowers default on loans, lenders can take control of the financed property and sell it, but the sale may not raise sufficient funds to cover both the debt and the legal costs involved in the process. Most lenders are reluctant to write loans for people with poor credit, and consequently industry insiders refer to such loans as high-risk mortgages.
Credit reports contain detailed information about the past payment history of borrowers. Foreclosures, charged-off credit cards, and unpaid debts remain on credit reports for up to seven years. These negative credit events result in lower credit scores, as do frequent late payments on existing loans. Mortgage companies normally only lend to loan applicants with good credit scores, which are sometimes called prime scores. People with lower scores are described as having subprime scores, and there are some companies who specialize in underwriting subprime mortgages for high-risk borrowers.
Lenders that write high-risk mortgages assume a greater degree of risk than lenders that only write loans for people with good credit. To mitigate that risk, high-risk lenders charge higher fees and write loans with higher than average interest rates. High-risk borrowers are more profitable for mortgage companies than people with good credit, as long as they make timely payments. People who make timely payments gradually improve their credit score and over time become eligible for low rate refinance loans. Most high-risk mortgages include significant early payoff penalties, so borrowers must weigh the possible savings of a refinance loan against the cost of penalty fees for paying off the existing loan prematurely.
Investment companies often buy high-risk mortgages from lenders and convert the loans into bonds known as Mortgage Backed Securities (MBS). The investment firms often buy thousands of loans and package the loans together in investment funds. Bonds that are secured by the fund containing the loans are then sold to investors. Interest payments that the investors receive for the bonds are comprised of interest payments made by homeowners making monthly payments on the underlying mortgages. Bonds tied to high-risk mortgages pay higher yields than other types of debt securities but also expose investors to greater risks, as the bonds lose value whenever homeowners default on the mortgages.