Subprime mortgages became notorious thanks to their role in the housing crisis that fueled the Great Recession of 2007-2009. But if it’s your first time buying a home, then you might still be unclear on what exactly are subprime mortgage loans.
As the name suggests, subprime mortgages are less than ideal because they come with higher interest rates. These mortgages are typically offered to borrowers who are considered riskier to lend to due to their weak credit records.
Unfortunately, not all homebuyers understand the downsides that come with a subprime mortgage before accepting one, which could lead to financial trouble down the line. Here’s what you need to know about subprime loans:
- What Is a Subprime Mortgage?
- The Risks of Getting a Subprime Mortgage
- The Difference Between Prime and Subprime Mortgages
- Types of Subprime Mortgages
- Alternatives to a Subprime Mortgage
- The Bottom Line on Subprime Mortgages
What Is a Subprime Mortgage?
A subprime mortgage is a home loan that comes with a higher interest rate because the borrower’s credit history is impaired. Poor credit indicates that a borrower is less likely to repay a loan, so lenders charge higher rates to compensate for the increased risk of lending money to them.
Lenders may have different criteria for evaluating borrower risk. You could be offered a subprime mortgage from one lender but qualify for a prime mortgage with another.
Generally, however, borrowers with subprime mortgages have a credit score below 620 and weak credit characteristics, such as delinquent payments, bankruptcies, or a high debt-to-income ratio, which shows a limited ability to cover living expenses. Or the borrower may have limited experience with credit and can’t prove how well they would handle debt.
In addition to having higher interest rates, subprime mortgages tend to be less predictable. That’s because they are typically offered as adjustable-rate mortgages, which means the interest rate is subject to change at regular intervals based on market conditions. It’s possible that the rate on an ARM could suddenly jump and drive up the borrower’s monthly payments.
The Risks of Getting a Subprime Mortgage
Homebuyers shouldn’t commit to a subprime mortgage before carefully weighing the risks involved with this type of home loan. If a lender identifies you as a subprime borrower, then you may already be in tight financial circumstances.
“Simply put, subprime borrowers are higher-risk borrowers and the risk is that their financial circumstances will not allow them to keep current with the payments and that the loans will fall into default,” says Robert R. Johnson, a professor of finance at Creighton University in Omaha, Nebraska.
If the subprime mortgage is an ARM, then fluctuating market rates could result in further strain on the borrower’s financial situation.
“One of the biggest potential risks of subprime mortgages is that many of them are adjustable-rate mortgages,” Johnson says. “The initial interest rate is often fairly low, but the risk the borrower runs is that if interest rates in the overall market rise, then the rate on their mortgage will adjust upward and payments can increase markedly. Some borrowers may not be able to bear the cost of higher mortgage payments and may have to default on their mortgages.”
Are subprime mortgages illegal?
Subprime mortgages aren’t illegal, and there could be situations where it’s reasonable for a borrower to accept one. For example, if a borrower’s credit is continuously improving and they can afford the subprime mortgage, then they could plan to refinance to a better interest rate down the line.
“Subprime mortgages, if issued conscientiously, can make markets more complete by giving a wider range of borrowers access to credit,” Johnson says.
These types of loans remain notorious due to the subprime mortgage crisis of 2007-2010. A rise in subprime lending led to an unsustainable period of growth in both housing demand and home prices. As high-risk borrowers began defaulting on loan payments and lenders started suffering losses, the housing bubble burst and home prices plummeted. The ripple effect destabilized financial markets, dealt a major blow to the U.S. economy, and served as a catalyst for the Great Recession.
Following this crisis, the Consumer Financial Protection Bureau was created in part to increase federal oversight of financial products being offered to consumers. The CFPB issued new regulations to protect borrowers from irresponsible lending, requiring mortgage lenders to confirm that prospective buyers can afford their mortgage.
The Difference Between Prime and Subprime Mortgages
Your credit score affects the mortgage rate that you’re offered. Prime mortgages have lower interest rates because they are intended for borrowers with the best credit histories. Subprime mortgages come with higher interest rates and are meant for borrowers with weak credit, who don’t meet the qualification requirements for prime mortgages.
Additionally, prime mortgages can be fixed-rate or adjustable-rate loans, while subprime mortgages tend to be ARMs. Other differences may include higher fees, smaller loan amounts, and bigger down payment requirements for subprime borrowers.
Which lenders offer subprime mortgages?
Some subprime lenders specialize in loans for borrowers who don’t qualify for conventional mortgages. But many lenders that provide traditional loan products also offer subprime mortgage programs.
Before applying for a mortgage, be sure to research information on the lender’s reputation, and look through their customer service reviews.
Types of Subprime Mortgages
Subprime mortgages carry higher interest rates, but they aren’t all structured the same way. Here’s a breakdown of the different types of subprime mortgages and how they work.
Subprime adjustable-rate mortgage
The interest rate on an adjustable-rate mortgage can change over time. After an introductory period, the borrower’s interest rate adjusts at regular intervals according to market rates. Because ARMs typically start at a lower interest rate compared with fixed-rate mortgages, the borrower’s monthly payment is likely to increase after this initial period. The unpredictability of ARMs makes this loan type riskier, because the borrower’s monthly payment isn’t guaranteed.
Subprime fixed-rate mortgage
With a fixed-rate mortgage, the borrower’s interest rate is locked in when they take out the loan. The difference between prime and subprime fixed-rate mortgages is that the subprime loans may have longer repayment periods in addition to higher interest rates. Instead of the standard 30-year or 15-year loan term, some subprime fixed-rate mortgages have repayment periods that can be 40 or 50 years long — leaving more time for interest to accrue.
Balloon mortgages allow borrowers to make smaller monthly payments at the beginning of their loan term. However, at the end of the repayment period, a large sum is due all at once — and it’s usually more than twice as much as the borrower’s average monthly payment. In fact, this sum could be tens of thousands of dollars. This type of loan is risky because the borrower might not be able to afford the balloon payment, depending on their financial situation at the end of the loan term.
With a dignity mortgage, the borrower pays a higher interest rate for a defined period — often five years. If they consistently make their monthly payments on time, then the interest rate on their mortgage will be reduced to the prime rate. In addition, the extra interest paid will go toward reducing the borrower’s loan balance.
An interest-only mortgage allows the borrower to pay only interest — and none of the principal — for an initial period up to 10 years. That means their monthly payments can be lower at the beginning of the loan term. After the initial period ends, the borrower must start paying down the mortgage principal as well, and their monthly payments will roughly double. The amount of time that the borrower has to repay the principal is shorter compared with the loan term, so the increase is significant.
It’s important to note that the borrower doesn’t build any equity in their home during the interest-only period. So, borrowers with this type of loan face a higher risk of loss if they need to sell their home when property values are flat or declining.
Negative amortization loan
Typically, borrowers make regular payments to gradually decrease the total amount they owe. This process is called amortization.
With negative amortization, the borrower’s payments aren’t enough to cover the interest owed. The unpaid interest is added to the principal balance, so the total amount that they owe actually increases. A negative amortization loan is risky because the borrower could end up owing more than their home is worth. If they have a hard time making their mortgage payments, they could be at risk of foreclosure.
Alternatives to a Subprime Mortgage
If you have an impaired credit history, there are options aside from looking into how to get a subprime mortgage. Other loan options could help you achieve your homebuying dreams without putting you in financial peril.
Johnson says subprime mortgages should be considered only after borrowers have explored government programs for people with poor credit. These include loans insured by the Federal Housing Administration, Veterans Affairs, and U.S. Department of Agriculture.
Mortgages backed by the government protect the lender from losses if the borrower is unable to pay their mortgage. Due to the reduced risk to lenders, government-backed loans can have lenient eligibility requirements compared with conventional loans.
For borrowers with poor credit, FHA loans are often the cheapest mortgage option. These loans are issued by private lenders but backed by the Federal Housing Administration. They allow for lower credit scores compared with conventional loans, as well as a 3.5% down payment. However, borrowers are required to pay an upfront and ongoing mortgage insurance premiums.
To learn more about FHA loans, you can go to the Department of Housing and Urban Development.
VA loans are insured by Veterans Affairs and offered to military service members, veterans, and their surviving spouses. The VA doesn’t require a minimum down payment, but whether a down payment is necessary ultimately depends on the lender. Borrowers also don’t need to pay for mortgage insurance. However, they must cover the VA funding fee as a one-time payment at closing or through financing.
To find out if you qualify for a VA loan, visit the VA’s website.
USDA loans are offered to borrowers in rural areas who meet certain low- to moderate-income eligibility requirements. These loans are backed by the U.S. Department of Agriculture, don’t require a down payment, and can be cheaper compared with FHA loans. However, borrowers must pay for mortgage insurance as well as an upfront fee.
For more information on what you need to qualify, consult the USDA’s website.
The Bottom Line on Subprime Mortgages
Subprime mortgages can make it possible for borrowers with weak credit to get a home loan when they otherwise wouldn’t qualify. However, the deal comes with strings attached — like a higher interest rate — and the borrower could face considerable risk, depending on the terms of the mortgage. So, if you’re thinking about accepting a subprime loan, make sure you understand all the drawbacks before signing on the dotted line.