In the real estate industry, borrowers have access to numerous types of mortgage loans. While many borrowers seek prime mortgages, it’s possible to apply for a subprime mortgage. Since this type of mortgage is usually provided to people with damaged credit records, it comes with higher interest rates.
While prime mortgages can be either adjustable or fixed-rate loans, subprime loans always come with adjustable interest rates. Lenders assess a higher interest rate to minimize the risk they take on when they approve the loan. If you apply for a subprime mortgage, your interest rate might increase considerably over time.
To understand how a subprime mortgage works, you need to compare it to a prime loan. Prime mortgages can be obtained by qualified borrowers who have excellent credit histories and ample income. The lender will be able to approve the loan without taking on much risk. An example of a prime mortgage is a conventional loan, which is mainly available to borrowers with credit scores of 700 or higher.
You can gain approval for a prime mortgage even if your down payment is just 3-5% of the home’s sale price. In comparison, subprime mortgages usually require higher down payments that range from 15-35%. By providing a larger down payment, you can reduce the lender’s risk. The following guide answers the question “What is a subprime mortgage?”
Why Are Subprime Mortgages Risky?
A subprime mortgage gives you the opportunity to buy a home even if your financial situation isn’t great. While homeownership is a compelling reason to take on a subprime loan, these mortgages are risky. For example, the interest rate on a subprime mortgage can be as high as 10-12%.
The high interest rate is designed to compensate for a higher default risk. If you eventually default on the loan after missing some payments, the lender may still have recouped a significant percentage of the total costs. However, a high interest rate will cause your monthly mortgage payments to increase.
For example, let’s say that you apply for a $300,000 mortgage on a $400,000 home, which means that you’ll be making a $100,000 down payment. If you’re approved for a 30-year conventional loan, you may receive a 6.5% interest rate. While you’ll likely pay a few hundred dollars in insurance payments and property taxes every month, your monthly payment will be $1,896 with the principal and interest.
If you’re unable to qualify for a conventional loan, you may be tasked with seeking a subprime mortgage that comes with a 10% interest rate. When using the same $300,000 loan amount, your monthly mortgage payment will be $2,632 in principal and interest. The loan will also have an adjustable interest rate, which means that your monthly expenses might eventually increase.
Adjustable-rate mortgages often reflect the market. If the average interest rate for subprime mortgages increases, yours will likely go up as well. Make sure you account for the risk of a rising interest rate before you apply for a subprime mortgage.
This type of mortgage is also risky for borrowers with low credit scores. While this loan might allow you to purchase a home, there’s a reason why lenders don’t approve conventional mortgages for borrowers with bad credit. A low credit score likely means that you’re at a higher risk of defaulting on the loan because of inconsistent income or a poor financial situation. Thoroughly assess your finances to ensure you can make the monthly payments that come with a subprime mortgage.
Who Qualifies for a Subprime Mortgage?
If you wish to qualify for a subprime mortgage, you’ll need to meet the following criteria:
- A credit score above 620
- A debt-to-income ratio that’s 0.5 or lower
- Decent credit history
- Moderate income level
- On-time loan or credit card payments
- No bankruptcy in the last 60 months
- No foreclosure in the last 24 months
If you have a credit score that’s below 620 or a late payment in the past 12 months, it might be more challenging for you to obtain a subprime loan. The same is true if you’re a self-employed individual or retiree.
However, you may still be able to secure a loan. Lenders will assess your level of risk to determine if you can be approved for a subprime mortgage. If you don’t meet the requirements, your lender could increase your interest rate to reduce their risk.
Types of Subprime Mortgages
From adjustable-rate mortgages to balloon payment loans, there are several types of subprime loans that you can apply for.
Adjustable-Rate Mortgages (ARMs)
An adjustable-rate mortgage usually comes with a fixed term, during which the interest rate won’t change. For example, if you qualify for a 3/27 ARM, your interest rate will stay the same for three years. Many lenders have limited how much rates can increase during a loan.
Interest-Only Mortgages
If you’re approved for an interest-only loan, every mortgage payment you make for the first seven or 10 years will pay off the interest. Once this term ends, you’ll pay a combination of interest and principal. The main advantage of this approach is that your monthly payments should be lower at first. However, you won’t build equity in your home until the interest-only period ends.
Balloon Payment Mortgages
A balloon mortgage is a less common type of subprime mortgage that comes with fixed monthly payments. These payments are low. However, the loan term ends with a large payment of the remaining loan amount. Your final bill could amount to tens of thousands of dollars.
It’s not easy to obtain a balloon payment mortgage in today’s market. Once the Consumer Financial Protection Bureau (CFPB) established guidelines for qualified mortgage (QM) loans, most lenders stopped offering balloon mortgages because of the amount of risk they carried.
Subprime Mortgages vs. Prime Mortgages
There are many differences between prime and subprime mortgages. For example, prime loans can only be accessed by qualified borrowers who aren’t risky to lend to. If you see that a mortgage loan comes with rates that are “as low as” 5%, only qualified borrowers with high credit scores will be approved for these loans.
Lenders often use credit scores to determine loan eligibility. If you have a credit score of 750 or higher, you may qualify for a prime mortgage. A credit score of 700 or lower means that your mortgage will likely be a subprime one. If you qualify for a subprime mortgage, be prepared to make a high down payment and receive an elevated interest rate.
Prime mortgages are offered to borrowers with higher credit scores because lenders are more confident that they can make their monthly payments on time. Let’s say that you’re buying a $400,000 home with a down payment of $100,000 and an interest rate of 10%. Once you pay off the loan, the total cost will be $647,777.
If you qualify for a prime mortgage, you may be able to purchase the same home with a down payment of just $12,000, which is 3% of the sale price. If your interest rate is 7%, you’ll end up paying $541,295 over the 30-year term, which is more than $100,000 lower than what you’d pay with a subprime mortgage.
The Role of Subprime Mortgages in the 2008 Financial Crisis
The 2008 financial crisis primarily occurred because of defaults on subprime mortgages. Lending standards weren’t as strict back then, which meant that many borrowers received NINJA loans. These loans were approved for borrowers with no income, no job, and no assets. A buyer could state that they earned $200,000 per year but didn’t need to prove the claim with documentation.
In many cases, these borrowers were unable to make their mortgage payments once the housing market began to decline. While subprime mortgages are still around, borrowers now have all the information they need to make an informed decision. The 2008 financial crisis made it clear that borrowers should avoid applying for subprime mortgages if they’re not confident that they can make the monthly payments.
Can You Avoid Subprime Mortgages?
If you wish to buy a home but want to avoid applying for a subprime mortgage, consider taking steps to improve your credit score beforehand. By making timely payments and keeping your credit utilization low, you should be able to steadily increase your score. If you push your score above 720, you might get access to prime mortgages.
It’s also a good idea to explore options like FHA, VA, and USDA loans. For example, an FHA loan is available to low-income individuals with a credit score of at least 580. Even if your score ranges from 500-579, you can qualify with a 10% down payment.
VA loans are available to veterans and active members of the armed forces. They don’t require down payments. As for USDA loans, they are designed to be used in rural-designated areas. If you have a low or moderate income, you might qualify for a USDA loan.
When searching for the best mortgage deal, make sure you compare terms and interest rates. If you select an adjustable-rate mortgage, the lender must have a limit on how much the rate can increase over time.
Conclusion
Subprime mortgages are riskier loans that are available to borrowers with lower credit scores and income. If you don’t qualify for a conventional loan or another type of prime mortgage, you might be approved for a subprime loan. There are, however, many risks associated with this type of mortgage. It’s an adjustable-rate loan, which means that your monthly payments can increase over time. For better loan options, consider improving your credit score and exploring alternatives.