Starting today, Personal Finance Analyst is kicking off a regular weekly feature: Mortgage Tuesdays.

Every Tuesday we’ll be featuring topics related to mortgages and mortgage lenders; in short, everything you ever wanted to know and then some about borrowing money to purchase property.

In case you’ve been living in a cave since last summer and have just now emerged with the thought of possibly buying a house (to replace that cave), you might not know that the entire US is staggering under the weight of a burst housing bubble, made much, much worse by a wave of subprime mortgage defaults and foreclosures. You may be asking yourself,

“What exactly is ’sub-prime’ lending anyway, and how can I avoid getting tangled up in it?”

Sub-prime simply refers to any kind of loan made to a borrower the lender considers risky or less than ideal. Some people fall into this category through no real fault of their own: recently divorced persons, people who have been at their jobs less than two years, people who work for themselves, and people with nothing negative on their credit records but nothing positive either.

Other prospective borrowers fall into the ’sub-prime’ category because of bad credit, a past bankruptcy or foreclosure, or a high ‘debt-to-income’ ratio. When a mortgage lender decides to loan money to a buyer who falls into one of these categories, and that lender builds in features such as higher interest rates to compensate for the increased risk of lending to that person, that loan is called a sub-prime mortgage.

“What is a debt-to-income ratio?” you may well ask.

Your debt-to-income ratio consists of your monthly regular expenses (such as rent or mortgage payments, credit card payments, car payments, taxes and insurances, etc.) divided by your gross monthly income. Say you pay $735 a month in rent, you have a car payment of $350, and your minimum payment on your VISA card is $50. You make $2500 a month gross. You divide your total monthly debt of $1135 by your gross monthly income of $2500 for a debt-to-income ration of 45.4%

When mortgage lenders look at your credit report, not only are they looking for on-time payments and no past defaults or bankruptcies, they are looking for a debt-to-income ratio of no more 36%, with no more than 28% of that debt tied up in housing or rent expenses. So, in our example above, that person with the $350 car payment and the $735 rent payment would probably not qualify for the best rates on a conventional mortgage and would be instead looking at sub-prime rates.

Should our made-up person (let’s call him Bob) consider a sub-prime mortgage, or should he pay off his car and his credit cards so he can get a conventional mortgage at a good rate?

That’s not an easy question to answer, but there are some things Bob should do before he makes a decision or signs any papers. Here are some general questions Bob should ask himself:

1) Is this a reputable lender or a small lender that a broker found for me? If you’ve never heard of the lender, there’s a good chance your loan will be immediately sold to some other financial institution. This alone should make our potential homeowner Bob think twice. Some large reputable lenders do write sub-prime mortgages and keep them on their own books, but most don’t. Wells Fargo Home Mortgage is one major lender that does write and service their own sub-prime mortgages. If you think you might want to take out a sub-prime mortgage, look for a large, reputable lender that underwrites and services its own loans first and foremost.

2) What are the terms of the mortgage? Before Bob even asks about the interest rates, he MUST read the contract thoroughly, ask questions, even hire an attorney if he has to, in order to make sure he understands the terms. Many people who got into trouble with sub-prime mortgages agreed to loans that offered very low initial rates but had regular rate hikes written right into the contract. Some sub-prime mortgages even offered zero interest for five years followed by a variable rate structured in such a way that you could, in theory, end up owing more on your home the longer you paid on it. When that happens, it’s called negative amortization, meaning you never touch the principal on the loan and simply owe the lender more and more interest every year. Ideally, Bob should look for a fixed rate loan (the interest rate stays the same over the life of the loan), or a variable rate loan with a cap on both how much the interest can go up each year and over the life of the loan.

3) Can I afford the worst case scenario? Many people go into sub-prime mortgages counting on things getting better and better for them, because they really, really want a house. This is a very bad way to approach a sub-prime option. First of all, you wouldn’t be considering a sub-prime loan if things in your life hadn’t already gone less than well, so how logical is it to assume this will magically change? Look at what you will pay each month if your life goes great, and what you will pay if every negative consequence actually comes to pass. Are you still in your home and better off in both cases? Bob should not accept an 8% variable rate mortgage with a 10% cap on the rate over the life of the loan if he can’t afford the payment should the rate hit the maximum 18%. Period.

4) Am I feeling pressured or confused by the broker or lender? Bob should politely excuse himself and leave. Don’t answer when the lender calls back 400 times either. Find another lender. Talk to other people who had good experiences and find someone who treats you with respect and patience. Never, never let a broker’s need to close a sale cause you to commit to something you don’t fully understand or want. If you are feeling uncomfortable, that alone is a sign that you probably have a good reason to be nervous. Thank the person, get out as fast as you can.

If these questions have you feeling cautious just reading them, good!

You should be cautious. Very cautious. A home is probably the single biggest purchase you will ever make. If now is not a good time, pay down your debt, save your money, wait it out. It’s harder to get a sub-prime mortgage now than it was at the height of the housing bubble, but predatory lenders are still out there doing their thing. Don’t let yourself be victimized by them.

Here’s an idea: Stay tuned for the rest of the PFA mortgage series every Tuesday!

Stick around, and you’ll be armed to the teeth (with good information) that will enable you to get the best deal possible and truly live happily ever after.

That’s what it’s all about after all. Am I right?