Sub-prime loans are largely responsible for pushing the real estate market into the stratosphere in years past. They enabled people who would not normally be able to finance a home a shot at the American dream.

Now that the housing bubble has popped, or is at least deflating rather quickly, many sub-prime borrowers who negotiated unconventional loans are feeling the heat. Some lenders are facing bankruptcy as a result of high foreclosure rates on sub-prime deals. But it could be the people who bought homes with fancy financing that are paying the ultimate price.

Defining Sub-Prime Lending

To understand the sub-prime market, it's important to clarify just who sub-prime lenders and borrowers are. Sub-prime lenders offer loans to borrowers who do not qualify financially for traditional mortgages. Many times sub-prime lenders are independent organizations, but increasingly they've become a subset of larger mainstream banks and lending organizations. Sub-prime lenders rarely advertise themselves as such. The way they are identified is by the prices of their financing options, including higher rates of interest, which will nearly always cost sub-prime borrowers more in the long run.

Sub-prime borrowers are those who do not qualify for prime loans. This is largely due to a poor credit rating. It may also be because adequate funds are not on hand for a substantial down payment on a home.

Sub-prime lenders were seen as heroes when they helped millions realize their home-buying dreams. But these lenders can also be seen as money-hungry enemies. Many time sub-prime lenders actively solicit borrowers who would normally qualify for prime mortgages. Whether through lack of knowledge or research, these borrowers get hooked by the sub-prime marketing strategy and end up getting roped into a mortgage that will cost them more. In fact, many sub-prime lenders will target current mortgage holders with refinancing schemes and money-back options that seem too good to be true; many, in fact, are. Sub-prime loans were also the mainstay of the flipping phenomenon, where borrowers didn't worry about financing terms since they believed their flip would turnover quickly in the sellers' market.

Risky Options

Sub-prime lenders employed "tricks" to make loans more affordable to those who couldn't swing prime mortgages. They lowered underwriting standards and offered a bevy of "affordability" products, like extra-long-term or "interest-only" mortgages (in which principal payments are deferred for a time) and loans with low teaser interest rates, known as hybrid mortgages, that balloon after a few years.

Today, these risky lending options have backfired. With slowly rising interest rates, many sub-prime borrowers have found themselves unable to pay the escalating mortgage bills. As a result, more and more are defaulting on their loans. This has a trickle-down effect to lending organizations.

Late payments increased to around 12.6 percent last autumn, according to Morgan Stanley, up from about 7 percent at the end of 2003. And many sub-prime lenders are closing their doors, forced into bankruptcy. Big banks are also facing the heat. General Motors, which subsidizes lending organization Residential Captial, may have to take a $1 billion hit to cover bad loans. Due to sloppy lending, HSBC has seen bad-debts rise to over 35 percent, nearly $10 billion dollars as of 2006.

Getting the Best Deal

If you're looking for a mortgage, consider these tips to avoid the possible pitfalls of sub-prime lending.

· Don't jump on a mortgage solicitation without first shopping around with other lenders.

· Know your financial standing and credit score. Sit down with a prime lender and talk about eligibility for mainstream financing.

· Keep in mind that the too-good-to-be-true scenarios often are. If you cannot afford a home right now with mainstream financing, think about whether a few changes down the road (saving more for a down payment, addressing debt) might make it possible in the near future.