What Is A Subprime Mortgage?
JW
Last updated 03/19/2024 by
Joseph WalesSummary:
A subprime mortgage, also known as a non-prime mortgage, is a type of mortgage issued to consumers with low credit ratings, usually below 620. The low credit rating prevents many borrowers from accessing conventional loans with lower interest rates and favorable terms. Mortgage lenders view borrowers with low credit ratings as having a greater-than-average risk of defaulting on the loan.
Subprime mortgages were one of the primary drivers of the financial crisis that led to the great recession. Lenders approved many mortgages that borrowers defaulted in the years leading to the subprime mortgage crisis.
According to Credit Union National Association analysis of Home Mortgage Disclosure Act data, around 30% of all mortgages in 2006 were subprime. Of course, subprime mortgages still exist today. However, as the graph shows below, most borrowers have a credit score above 680 (as of 2022).
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What is a subprime mortgage?
A subprime mortgage is a home loan issued to borrowers with low (i.e., subprime) credit scores. As a result, subprime mortgages have higher interest rates and less favorable terms than prime mortgages. Typically, subprime mortgages are adjustable-rate mortgages (ARMs), which means the interest rate could increase in the future. This is because lenders view subprime borrowers as a higher risk of defaulting on a loan.
Notice that the word “subprime” does not refer to the interest rate attached to the mortgages but to the borrower’s credit rating. Typically, subrime borrowers are defined as borrowers who have a credit score below 620. These borrowers will have to bear the corresponding higher interest rates and stricter requirements. It’s wise for individuals with low credit ratings to wait and build up their credit histories before applying for a mortgage. This will allow them to qualify for conventional prime loans.
If you have a subprime mortgage and your credit score has improved since you got your mortgage, you may want to consider a mortgage refinance. Here is SuperMoney’s list of the best mortgage refinance lenders.
How do subprime mortgages work?
Subprime mortgages work like any other mortgage. You have to fill in an application and provide documentation to prove you can afford the monthly payments.
Lenders are particularly careful when underwriting a mortgage application from subprime borrowers for two reasons. First, subprime borrowers are considered higher risk than prime borrowers. Second, the Consumer Financial Protection Bureau, CFPB, regulates subprime mortgages. This government agency was started as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act to mitigate the subprime crisis.
For instance, the CFPB requires that borrowers receive counseling from a HUD-approved (U.S. Department of Housing and Urban Development) counselor before getting approved for a high-cost mortgage.
Lenders who offer subprime mortgages are also required to follow Dodd-Frank standards, which include confirming the borrower’s ability-to-pay (ATR) provision. This requires the lender to verify that the borrower can afford to repay the loan. If lenders violate the ART rule, they can be subjected to regulatory enforcement or be sued.
Are subprime mortgages bad or illegal?
No. Subprime mortgages are not necessarily bad and they are not illegal, as long as lenders follow general mortgage regulations. Sometimes they provide the only option for borrowers who have subprime credit scores.
It is true that the subprime mortgages of the past were bad news, but they weren’t illegal. It is true that many lenders would provide confusing information and approve applications of borrowers who clearly couldn’t afford the payments.
Things have changed a little since. However, when originated in massive numbers, subprime mortgages can be dangerous to the mortgage industry, borrowers, and the economy as a whole.
Subprime vs. prime mortgages
Prime mortgages have lower interest rates and better terms than subprime mortgages. When you see mortgage ads that say rates “as low as XYZ%,” you are seeing the best rate available to prime borrowers. Prime mortgages often have relatively small down payment requirements- as low as 3-5% of the property’s value. Highly qualified borrowers with good credit scores can qualify for prime mortgages. Note that some lenders require higher credit scores, such as 680, to qualify for prime rates.
On the other hand, the interest rates on subprime loans are much higher- as high as 8-10%. Besides, lenders require a higher down payment as high as 25-35% to cover the risk.
Here is a quick comparison of the rates, monthly payments, and total interest paid with a prime mortgage and a subprime mortgage.
| Loan Amount | Down payment | Interest Rate | Loan Term | Monthly Payment | Total Interest |
|---|---|---|---|---|---|
| $300,000 | 3% to 20% | 4% | 30 years | $1,432 | $215,609 |
| $300,000 | 20% | 8% | 30 years | $2,201 | $492,466 |
Types of subprime mortgages
Subprime fixed-rate mortgage
The subprime fixed-rate mortgage operates like the conventional fixed-rate mortgage. Borrowers get a set rate, while the monthly payment stays the same for the loan repayment period. The major difference is that, unlike the conventional fixed-rate with the 15-30 years, subprime fixed-rate mortgages can sometimes have longer terms, such as 40 years.
Subprime adjustable-rate mortgage (ARM)
Subprime adjustable-rate mortgages, ARMs like the 3/27 ARM, are mortgages where borrowers get a fixed interest rate for the initial three years. Afterward, the rate readjusts annually for the remaining 27 years. These adjustments depend on the going market rates and a margin. Mortgage lenders often have a ceiling on how much the rate can increase. However, if borrowers can’t make the peak monthly repayment, they could risk default.
Interest-only loan
Interest-only mortgages, also known as balloon mortgages, usually have lower monthly payments because borrowers only have to pay the interest on the loan — not the principal. Once the term ends, usually 7 to 10 years, the borrower must either return the entire balance in a single balloon payment or refinance.
Dignity mortgage
With the dignity mortgage, borrowers make down payments of at least 10% and take on a high-interest rate. When borrowers make timely payments for a specific period-usually five years, the money paid toward the interest is used to reduce the loan balance. The interest rate is reduced to the prime rate, or the rate most prominent lending institutions charge the most creditworthy borrowers.
The rate is determined by the federal funds rate set by the Federal Reserve. The dignity mortgage could benefit borrowers who can afford large repayments during the start of the loan term.
Benefits and risks
Although nobody dreams about getting a subprime mortgage, they are not all bad. Sometimes they are the only option available if you want to buy a home with poor credit. Here is a brief discussion of the main pros and cons.
Who offers subprime mortgages?
The biggest credit unions and banks do not offer subprime loans. Subprime mortgages are available via a portfolio lender or a lender advertising no-doc, bad-credit, or non-qualified mortgages. They are also found in loans aimed at borrowers with “recent credit events” like foreclosure or bankruptcy.
How do I know if I have a subprime mortgage?
According to Experian, approximately 33% of all borrowers are in the subprime classification. You could have a subprime mortgage if the mortgage has a term longer than 30 years or a higher interest rate.
Also, if you had a down payment higher than 20% and were not buying an investment property or getting a jumbo loan, you could be in this category. You could also have a subprime loan if you had a history of a loan default, late payments, a credit score below 620, or a high debt-to-income ratio.
If you have a subprime mortgage, compare your credit when you applied to now. If your credit has improved since you last applied for a prime mortgage, you can refinance for a lower the rate and get better terms.
SuperMoney Tip: Just because a lender offers you a subprime mortgage doesn’t mean can’t qualify for a prime mortgage with another lender. You may also meet the requirements for an FHA loan. Remember that lenders and brokers generally are not obligated to offer you the best deal available and their goal is to make money.
Should you get a subprime mortgage?
A subprime mortgage is not the best option because of the high rates and other strict requirements. If you have a bad credit history, there are several options. VA loans and FHA loans are ideal. FHA loans, for example, accept credit scores as low as 500 with a down payment of at least 10%. There’s an array of first-time homebuyer assistant plans for a first-time homebuyer, some of which are credit improvement programs.
Alternatives to a subprime mortgage
Subprime mortgages are more expensive and have worse terms than regular mortgages. The good news is there are alternatives to consider. Here are three.
- FHA Loans: With a down payment of 3.5% and a credit score of at least 580, you can consider an FHA loan. With a credit score between 500-579, you can get an FHA loan with a 10% down payment.
- VA loans: These are ideal for veterans or active armed forces members. Backed up by the U.S. Department of Veterans Affairs, the loans don’t need a down payment and usually have lower credit rating requirements.
- USDA loans: These loans are designed for low-to-moderate-income borrowers in rural areas. With USDA loans, different lenders have different requirements.
Key takeaways
- A subprime mortgage is issued to consumers with low credit ratings, usually below 640.
- Subprime mortgages were one of the primary drivers of the financial crisis that led to the great recession.
- There are several types of subprime mortgages, such as fixed-rate, adjustable-rate, interest-only, and dignity mortgages.
- Subprime mortgages allow people with low credit scores to own a home without the grueling years of building a better credit score.
- They help borrowers fix their credit scores by using them to pay off other debts.
- The closing fees and costs are usually higher.
- Income is a determining factor for subprime loan qualification.
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