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What Is a Subprime Mortgage?

A subprime mortgage may be an option if you want to become a homeowner but have bad credit. These loans are for high-risk borrowers but come with their risks.

Before you consider a subprime loan, here are some things to know.

Who Are Subprime Mortgage Borrowers

Subprime mortgage applicants are those with low credit scores or negative credit records. Prime borrowers are those with solid credit and a track record of financial performance. Therefore, the lender is more likely to offer them a loan at lower interest rates.

Financial institutions use the term “nonprime” more often than subprime. However, the meaning remains the same. A borrower who has a credit score below 660 is considered to be subprime. A subprime borrower, according to the Federal Deposit Insurance Corp(FDIC), is also someone who:

  • At least two payments were more than 30 days late in the past 12 months, or one payment was more than 60 days late in the past 24 months
  • In the last 24 months, you have been charged with a judgment, foreclosure, or repossession.
  • Filled for bankruptcy within the previous five year
  • A debt to income (DTI) ratio of at least 50%

These types of high-risk borrowers can get home loans that are subprime or not prime.

Subprime might sound familiar due to the subprime mortgage crisis. Before 2008, lenders had much looser criteria for approving borrowers with poor credit scores or financial records. 

These loans were sometimes called no-doc loans, as some lenders didn’t require documentation of income.

Many of these borrowers defaulted on their loans eventually. Between 2007-2010, foreclosures rose dramatically, and banks lost a lot of money. The government had to bail out large banks while other banks merged or failed.

The Dodd-Frank Act of 2010, which was created in response to the subprime mortgage crises, was intended to reform financial regulation and prevent another one from ever happening. 

The act includes a lender requirement and the ability-to-repay (ATR) rule. This rule mandates that mortgage lenders establish a process to evaluate whether borrowers can repay the loan by its terms. It effectively ends the practice of no-doc loans.

Lenders must also underwrite loans by Dodd-Frank’s standards. These requirements can lead to a lawsuit or other regulatory action. 

Subprime borrowers must also attend homebuyer counseling by an approved U.S. Department of Housing and Urban Development representative.

Although there are stricter guidelines for subprime mortgages, they are still riskier than conventional mortgage loans.

Types of Subprime Mortgages

Subprime mortgages are similar to conventional mortgages. There are many types, including:

  • They Have Fixed-Rate Mortgages.

     This type of loan has a fixed interest rate for the mortgage term, and monthly payments are the same amount. Fixed-rate subprime mortgages are typically longer than conventional mortgages, which have a repayment term of 15 to 30 years. However, they can last up to 40 years.

  • Adjustable-Rate Mortgages (ARM)

     Instead of one interest rate that is fixed for the entire loan term, subprime ARM provides a low introductory rate which eventually resets to a market index that it is tied to.
    A 5/1 ARM would mean that the borrower would be charged the initial rate for five years. The rate would then reset for the remaining 25 years. Lenders usually limit how much the rate may rise.

  • Interest-Only Mortgages

     The interest-only loan does not include the accrued interest over the first seven to ten years. After that, the payments will be used to pay down principal and interest over the remainder of the term.

  • Dignity Mortgages

     It is a mix of a conventional and subprime mortgage. Borrowers pay 10% down and will typically pay five years at a higher rate of interest.
    Borrowers who spend all of their bills on time will see their rate drop to the prime rate, which is the interest rate banks charge their most creditworthy customers.

Is a Subprime Mortgage Right For Me?

If you have bad credit, one option is to take out a nonprime or subprime mortgage. It’s not the only option. You may also be eligible for a government-backed loan such as the Federal Housing Administration (FHA) or U.S. Department of Veterans Affairs (VA) loan. 

These loans have lower down payments and credit requirements. Before you consider a subprime loan, it is important to weigh all options.

Nonprime home loans don’t only work for those with poor credit. Certain types of properties, like condos and log homes, are not eligible for conventional loans.

 A subprime mortgage may be an option for you if you are self-employed with a low taxable income. Foreign nationals living in the U.S. with no credit history will also be eligible.

Both the benefits and the risks

Subprime mortgages offer a way to secure home financing even if you aren’t eligible for other options.

But just because you are eligible for a subprime loan doesn’t mean that you should. There are many benefits to subprime mortgages, but there are also risks.

1.) Higher rates:

 Subprime mortgage applicants typically have low credit scores and other financial difficulties. This makes it riskier for lenders to offer this type of loan than traditional mortgages. 

Lenders charge higher interest rates to offset this risk. The average 30-year fixed-rate conventional mortgage rate is below 3%. However, a subprime mortgage rate can reach 8% to 10% and require larger down payments.

2.) Higher Down Payment:

 Lenders may also require higher down payments, ranging from 25% to 35% depending on the loan type. This is done to offset the risk of subprime loans. 

This can prove difficult if your home’s value is rising rapidly. You could end up being priced out of your preferred neighborhood. It is important not to invest too much of your liquid savings in your home. 

You should have enough money to cover your expenses and mortgage payment in case of financial emergencies.

3.) You Will Be Paying a Higher Monthly Payment:

because of the higher interest rate for a subprime loan. Lenders will verify that you don’t take out more than you can repay if your financial situation changes, such as losing your job or having a medical emergency. High Payments might become too much. You can cause severe damage to your credit score, and worse, you could be forced to foreclose.

4.) Longer Terms:

 A conventional mortgage typically has terms for between 15 and 30 years. Subprime mortgages can extend the repayment terms to as much as 40 years or even 50 years. A mortgage payment could take up a large portion of your life. This also means that your interest payments over the life of the loan will increase dramatically.

What is Required to Get Approved?

Subprime mortgages can be used for those with lower credit scores. However, lenders will not lend to anyone. Your credit score will not be sufficient to get a mortgage. Lenders prefer borrowers with credit scores between 580 and 660.

Subprime mortgage applications are the same as conventional mortgages. To prove your ability to pay the monthly payments, you will need to submit a lot of documentation, including a list of your assets and any current debts and proof of income via tax returns and paystubs.

What Can You Expect After You Apply

After submitting your application, supporting documents, and documentation, the lender will assess your creditworthiness and financial situation. 

The lender will examine your employment history, payment history, DTI ratio, and income history. The lender will give you a loan estimate detailing the terms and all fees. You have the option to accept or reject the offer.