What is a subprime mortgage?
Subprime mortgages (also known as non-prime or non-qualified mortgages) are for borrowers with a lower credit score, typically below 600, and prevent traditional loan approvals. Subprime mortgages tend to have fewer favorable terms than traditional loans, including higher interest rates and down payment requirements.
How do subprime mortgages work?
Subprime mortgages are in many ways similar to traditional mortgages. Apply for a mortgage, supply proof of income via your bank statement, W-2, and tax returns, and answer any additional questions that lenders may have during the underwriting process. If approved, you will receive the funds, close the house and then repay the loan according to the terms set by the lender.
However, you can get a subprime mortgage from a lender that offers subprime mortgages. Your local bank or credit union may not offer them. And the loan you receive has very different terms than if you were qualifying for a traditional loan.
Government protection for subprime borrowers
Subprime loans were one of the main drivers of the financial crisis that fueled the Great Recession. In the years leading up to the economic meltdown, lenders approved many subprime mortgages that borrowers were unable to pay back. In fact, an analysis issued by the Federal Reserve Bank of Chicago shows that over 20% of all mortgages born in 2006 were subprime.
Subprime mortgages still exist, but are currently regulated by the Consumer Financial Protection Bureau (CFPB). It was created as part of the Dodd Frankwall Street Reform and Consumer Protection Act, enacted in response to the subprime crisis. For example, the CFPB rules require subprime lenders to:
- We will clearly disclose the terms and fees of the loan. Borrowers must access the annual rate (APR) of the loan and payment schedule.
- Please refrain from issuing loans with certain features, such as negative amortization. This occurs when the loan payments do not fully cover the profits of the loan. Subprime lenders are also prohibited from prepaid fines.
- Make sure that borrowers who are taking subprime mortgages have received housing counseling. Counselors must be approved by the U.S. Agency for Housing and Urban Development (HUD).
- Evaluate whether the borrower is able to pay off the loan. This is also known as the provision of “review ability.”
“If you violate ATR rules as a lender, you may be potentially sued or subject to regulation enforcement,” said Arecy, director of corporate communications at Financial Communications. “Therefore, lenders operating in unqualified mortgage spaces have a strong incentive to ensure they are properly assessing far more borrowers than subprime lenders from 15-20 years ago.”
That “unqualified mortgage” designation also limits lenders’ legal protections, preventing many from operating in the space. “Lenders aren’t making the same kind of subprime mortgages they did in the Great Recession,” says Kilgore. “The biggest reason is regulatory issues.”
Subprime vs. Prime Mortgage
Both subprime and prime mortgages serve the same purpose. Funding for the purchase of a home. However, they have different terms and serve different borrowers.
Subprime and Prime Mortgage Requirements
| Credit score | down payment | interest rate | |
|---|---|---|---|
| Major Mortgage Requirements | 700+ | Low 3% | 6-7% |
| Subprime mortgage requirements | > 600 | 25%-35% | Over 10% |
Major mortgages are available to qualified borrowers who pose most risk to lenders. If lenders advertise a “low” rate at a certain percentage, these rates are typically reserved for borrowers qualifying for the maximum mortgage. These borrowers are also eligible to make a lower payment as low as 3 or 5% of the home price.
On the other hand, interest rates on subprime mortgages can be much higher. Often, it’s over 10%. Lenders usually also seek large down payments, such as 25% to 35%, to avoid large loans from risky borrowers.
Examples of Subprime and Prime Mortgages
Subprime lenders tend to charge borrowers more to explain the risk. Here’s how much these high costs can be added over the course of a 30-year mortgage:
| Prime | Subprime | |
|---|---|---|
| Home prices | $400,000 | $400,000 |
| down payment | $12,000 (3%) | $100,000 (25%) |
| interest rate | 7% | 10% |
| Loan period | 30 years | 30 years |
| Monthly payment | $2,581 | $2,632 |
| Total interest | $541,295 | $647,777 |
Types of subprime mortgages
Some of the types of subprime mortgages available are:
Subprime fixed interest rate mortgage
Subprime fixed-rate mortgages work similarly to traditional fixed-rate mortgages in that borrowers get set interest rates and monthly payments remain the same throughout the loan repayment period.
Compared to the typical 15 or 30-year period of traditional fixed-rate loans, subprime fixed-rate mortgages can have longer terms, such as 40 years.
Subprime Adjustable Rate Mortgage (ARM)
There are also subprime adjustable mortgages, or weapons, such as the 3/27 arm, where borrowers will win a fixed interest rate for the first three years, followed by fees for the next 27 years.
The adjustment is based on the performance and margins of the market index. Most lenders have a cap on how much your rate can go up, but if you can’t make a monthly peak payment, there may be a risk of default.
Interest-only loan
With an interest-only loan, the borrower will pay only interest for the first few years, usually between 7 and 10 years. This could mean that you will have less monthly payments at first, but you will not get repayments or capital from the principal.
Dignity mortgage
With a dignified mortgage, the borrower will pay a down payment of at least 10% and underwrite a high interest rate. If the borrower makes timely payments for a certain period (usually five years), the amount paid at the interest rate is used to reduce the loan balance, and the interest rate is reduced to the prime rate. This rate is determined primarily by the federal funding rate set by the Federal Reserve. This type of mortgage is beneficial if you can afford to make a large payment at the beginning of your term.
Pros and cons of subprime lending
When considering a subprime mortgage, consider the pros and cons, including:
Subprime mortgage replacement
Other options you might want to consider besides subprime mortgages include:
- FHA Loan: If your credit score is at least 580, consider an FHA loan with a down payment of 3.5%. If your credit score is between 500 and 579, you can reduce by 10% and qualify for an FHA loan.
- VA Loan: If you are a veteran, an active member of the military, or a surviving spouse, check out the VA loan. These loans, guaranteed by the U.S. Veterans Affairs Office, do not require a down payment and can lower your credit score requirements.
- USDA Loan: USDA loans are designed for low to middle income borrowers in designated areas of rural areas. Some qualifying locations are actually close to metropolitan areas. The lender may have relatively generous credit standards that will help you qualify.
Another option is simply to wait. Keep paying your bills on time and focus on taking steps to improve your credit. You might want to buy a house now, but you also don’t want to get stuck paying overwhelmingly high interest rates.
Is a subprime mortgage perfect for me?
Non-prime mortgages are not ideal. You will pay more interest over the life of the loan, and you may need to come up with a big down payment. However, lending standards are now relatively strict, making it difficult for buyers who have historically qualified for traditional loans. If subprime mortgages are the only way, if you can become a homeowner, it may be worth the downside.
You might consider subprime loans:
- You are not eligible for a traditional loan or a government-supported loan. One of these options is generally generally cheaper than subprime mortgages.
- You can afford to pay for your mortgage. Subprime mortgages are highly regulated, but have default risks. You and your lender will want to ensure that your income is stable enough to pay off your loan.
- There is an immediate reason to buy rather than continue renting. If you can wait for your mortgage to be taken out until your credits improve, you will probably get a better deal.
If you choose a subprime loan, remember that consumer protection is more robust than in the mid-2000s. You need to be aware of the potential costs of your loan, but your lender must give you the tools you need to do your research.
