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What Is a Subprime Mortgage?

A subprime mortgage helps people with low credit scores finance their homes. Today’s subprime mortgages function much differently than the ones before the Great Recession, but they still pose certain risks. However, they can serve as an advantage for the right borrower.

What Is a Subprime Mortgage?

Some lenders issue subprime mortgages to borrowers with low credit scores, who can’t obtain mortgages elsewhere. However, subprime mortgages usually carry high interest rates and closing costs and require large down payments to protect the lender in the event you fail to make your monthly payments.

Every bank or lender establishes its own credit score “cut-offs.” But generally, most subprime mortgage borrowers hold credit scores below 640. They also tend to have experienced at least one of the following:

  • Delinquency on bill payments for at least 30 days
  • Bankruptcy in the last five years
  • Large debt in relation to income

Subprime Mortgage Risks and The Great Recession

The concept of the subprime mortgage blossomed to help Americans achieve their dreams of owning a home despite their lack of access to conventional mortgages. However, these loans took on an infamous connotation at the dawn of the Great Recession in the early 2000s.

Subprime mortgage lenders were part of the cause behind the financial crisis that shook the country beginning in 2007. In essence, some of these lenders were handing out loans to people who couldn’t reasonably pay them back. In addition, several lenders started pooling loans into mortgage-backed securities before selling them to investors from individuals to hedge funds.

When hordes of borrowers defaulted on their loans, nearly everyone involved took a huge hit. People lost their homes, lenders lost their money and huge investments plummeted in value. The domino effect, along with other components of the financial meltdown, spread worldwide creating a global recession. But as the economy normalizes, several types of subprime mortgages have disappeared.

Prior to the recession, it wasn’t unheard of to be offered a subprime mortgage with no down payment or an adjustable rate mortgage (ARM) hybrid that let you choose what you wanted to pay. Optional ARM borrowers decided what to pay for an introductory period of about five years. The problem was that if you paid just a fraction of interest, your principal grew every month and so did the interest you paid in the long run.

Most borrowers planned to benefit from these options because they thought they would eventually sell the house at a higher price or refinance with a smaller rate. The major dip in home values during the Great Recession made this nearly impossible.

Modern Subprime Mortgages

Today’s subprime mortgages still cater to people with less-than-favorable credit scores. However, these loans undergo a much stricter regulation environment. The Consumer Financial Protection Bureau currently oversees subprime mortgages. Borrowers also need to take part in homebuyer’s counseling with someone approved by the U.S. Department of Housing and Urban Development (HUD) before securing a loan.

It’s important to note, however, that some of the post-recession regulations that affect subprime mortgage lenders composed parts of the Dodd-Frank Act. The fate of this law is uncertain. Bills such as the Mortgage Choice Act seek to amend portions of the Dodd-Frank Act, while others aim to dismantle it all together.

Regardless of what happens, it’s important to keep some points in mind. Always know how your mortgage works and where every penny you’re shelling out is going.

Furthermore, know when you’re actually dealing with a subprime mortgage. Today, the home loans may be called “alternative mortgage programs” or something along those lines. The point is that you may be dealing with a subprime mortgage if you get a loan when your credit score is in the low-to-mid 600s or below. So tread lightly, read all documentation and ask questions.

Types of Modern Subprime Mortgages

What Is a Subprime Mortgage?

In terms of structure, subprime mortgages now closely reflect their conventional counterparts. So-called “exotic subprime mortgages” such as option ARM loans and negative amortization loans are either extinct or extremely rare.

You’ll likely encounter a fixed-rate subprime loan with a fixed interest rate for the life of the loan. You can apply for 15-year and 30-year fixed-rate mortgages.

On the other hand, ARM subprime mortgages offer an introductory interest rate before turning to a variable rate based on market conditions. Common ARM loans include the 2/28 type. In this case, you pay the low introductory interest rate for the first two years. The variable interest rate applies to the remaining 28 years.

The Costs of Subprime Mortgages

Interest rates for subprime mortgages still tend to spike well above that of prime mortgages. Down payments hover up to around 30% of the home’s value.

In addition, subprime mortgages come with many of the same fees as their traditional counterparts such as closing costs. For the most part, closing costs tend to climb higher than they do for prime mortgages. In addition, you may be required to purchase private mortgage insurance, especially if you score a low down payment. The point is the lender wants to collect as much upfront to minimize risk.

Requirements for Getting a Modern Subprime Mortgage

The requirements for landing a post-recession subprime mortgages are becoming more strict. For example, you’ll need a credit score of about 680 to land one with modest rates. You’ll also need to provide many of the basic details and documentation needed to secure a conventional loan.

  • Last two years of pay stubs or relevant documentation of self-employment income
  • Last two tax returns
  • Credit score or evidence of non-traditional credit history like utility bills
  • Documentation of employment history
  • Evidence of additional income such as alimony checks
  • Paper trail of bills and other financial obligations

Alternatives to a Subprime Mortgage

Subprime mortgages don’t serve as the most ideal options for all borrowers, especially those with bad financial habits. Falling back on high-interest payments could plummet your credit score and push you into foreclosure.

However, individuals and families with low credit scores still have several options for financing their dream homes. Consider the following:

Federal Housing Administration (FHA) loans: These loans usually offer lower interest rates than conventional mortgages. Borrowers with credit scores of at least 580 can secure an FHA loan with a 3.5% down payment. People with lower credit scores may still qualify, but the process may be a bit stricter. However, individuals who’ve experienced bankruptcy in the last two years or foreclosure in the last three years don’t qualify for these loans.

USDA loans: The United States Department of Agriculture (USDA) issues low-interest loans with zero down payments to low-income individuals who wish to live in rural America. However, the USDA broadly defines “rural” and even some suburban locations fall into its radar.

VA loans: These loans support veterans and certain active duty members of America’s armed forces. VA loans typically offer zero money down. Fees usually dip to only about 2.15% to 3% of the loan, which you can rollover into the mortgage amount. The move would increase the interest you pay in the long run, however.

Bump up your credit score: If a prime mortgage seems a bit out of reach for the long term, consider holding off on buying a house. Address your current debt and boost your credit score by making timely payments. Remember: The higher your credit score, the lower your interest rate. Sometimes, it’s better to rent and secure your financial foothold before you go house hunting.

Shop around: Every lender has different standards for providing a loan. Just because one lender refused your application for a prime mortgage, doesn’t mean another would do the same.

Who Should Get a Subprime Mortgage?

what is a subprime mortgage

Despite the negative press that subprime mortgages got during and after the Great Recession, they may serve as an option for the right borrower.

Some people take out subprime mortgages with refinancing in mind. With an interest-only mortgages or ARM loans, they make timely payments when interest is low. This move boosts their credit scores. As a result, they’re more suited to refinance the entire subprime mortgage with a new conventional mortgage that carries favorable rates. Borrowers who expect major windfalls may be able to pay the entire subprime mortgage before higher interest rates kick in or well before the life of the loan ends.

Keep in mind, however, that a new loan will come with closing costs and a down payment. So make sure you save up to tackle these. Also, be honest with yourself. This strategy requires extreme financial discipline, so you may want to step back if you’re accustomed to missing payments or struggling with overall finances. Take a moment to get yourself together. When you do, you’ll be able to step into a home you can actually afford to call your own.

Tips on Getting a Subprime Mortgage

  • Even though subprime mortgages take different names and are more heavily regulated than they were in the pre-Recession days, don’t let your guard down. These loans still carry high interest rates. Know how much house you can afford and factor all fees and monthly payments into your budget.
  • Subprime mortgages may work if you have a solid plan to stick to payments and intend to later refinance for a better rate. But make sure you have the resources to do it. Plan for the worst and hope for the best.
  • You may think a low credit score limits you to subprime mortgages. Not so. Plenty of government agencies like the FHA, USDA and the VA can help you get a mortgage with modest rates even if conventional mortgage lenders turned you away. Or maybe renting is a better option for you now, while you pay off debt and work on that credit score.

Photo credit: ©iStock.com/courtneyk,©iStock.com/Fizkes, ©iStock.com/shapecharge

Javier Simon, CEPF® Javier Simon is a banking, investing and retirement expert for SmartAsset. The personal finance writer's work has been featured in Investopedia, PLANADVISER and iGrad. Javier is a member of the Society for Advancing Business Editing and Writing. He has a degree in journalism from SUNY Plattsburgh. Javier is passionate about helping others beyond their personal finances. He has volunteered and raised funds for charities including Fight Cancer Together, Children's Miracle Network Hospitals and the National Center for Missing and Exploited Children.
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