A subprime mortgage is a type of home loan issued to borrowers with low credit scores (often below 640 or 600, depending on the lender). Because the borrower is a higher credit risk, a subprime mortgage comes with a higher interest rate and closing costs than conventional loans.
The term “subprime” is confusing because it is used in contrast to “prime,” which can refer to the lending rate as well as the loan and borrower. So “subprime” may sound like a lower interest rate, but it really means lower quality (when referring to the loan) or creditworthiness (when referring to the borrower). It would be clearer to call these mortgages “non-prime,” which is what some lenders are doing now (partly to distance the loan classification from the financial crisis of 2007 – 2008, in which subprime mortgages played a major role).
Because of their history, subprime mortgages get a bad rap. But for people with weak credit histories who want to own their own homes, subprime loans are a great help. Of course, an alternative route is waiting a while to rebuild your credit or save a bigger down payment before applying for a conventional mortgage – a financial advisor can guide you. But if you are interested in taking out a subprime mortgage now, here’s what you need to know.
The Risks of Subprime Mortgages
In the mortgage business, borrowers with poor credit histories are considered high risk and more likely to default on their loans than borrowers with high credit scores. After all, would you loan money to someone with a habit of missing payments and borrowing more than they can pay back? That’s what runs through the heads of mortgage lenders when considering applications for subprime mortgages. So to compensate, they issue these loans with higher high interest rates and fees.
To put that into perspective, the average interest rate for a 30-year fixed-rate conventional mortgage hovered around 4.01% in 2019 (it’s even lower since the coronavirus-caused recession). Compare that to interest rates for subprime mortgages, which were as high as 10% in 2019. Remember, interest is the cost of borrowing money. So the higher the rate, the more you’ll pay in the long run. And when calculating your mortgage payments, you’d also have to crunch property taxes and other factors.
But that’s not all. Most lenders require a down payment on your mortgage. For conventional mortgages, it typically stretches from around 10% to 20% of the home’s purchase price. For subprime mortgages, that rate can go as high as 35%, though it can also go as low as 3%. When down payments are lower than 20%, you’ll typically have to get private mortgage insurance – or apply for an FHA, VA or USDA loan if you are eligible (more about these loan programs below).
It may seem like it’s nearly impossible to pay back a subprime mortgage when you look at the long-term cost. And that was the case for many people in the mid 2000s. In fact, people defaulting on subprime mortgages played a huge role in triggering the financial crisis of 2007 – 2008.
Following the Great Recession, subprime mortgages exist a bit differently today and they are under heavier regulations. But they still carry major risk. Below, we describe the kinds of subprime or non-prime mortgages available no .
Types of Modern Subprime Mortgages
Fixed-rate subprime mortgages: You can find subprime mortgages that lock in your interest rate for the life of the loan. These are similar to their conventional fixed-rate counterparts. But instead of 30-year terms, you’d likely find terms stretching from 40 to 50 years! While that arrangement can mean low monthly payments, you end up paying a lot more in interest in the long run.
Adjustable-rate mortgages (ARM): These types of loans also exist under the conventional mortgage umbrella too. Basically, you start off with a fixed interest rate before the rate begins to shift throughout the life of the loan. The size of that shift depends on whatever market index the loan is tied to and overall economic conditions. So it can rise and fall: sometimes minimally, sometimes dramatically. Terms for ARMs are usually 30 years. So when you see a “2/28 mortgage,” all that means is that the rate is fixed for the first two years. It would vary during the remaining 28 years. Or you can see it broken down like a 5/1 ARM. This means the rate is fixed for five years before it becomes variable once every year. Some people aim to clean up their credit by the time the variable rate kicks in, so they can qualify to refinance their mortgage with better rates and terms.
Interest-only mortgages: These were common at the dawn of the Great Recession. Basically, you’re required to make interest payments only for a specific amount of time. It’s usually five to seven years. At the end of that term, you begin to pay off the principal (the initial amount you borrowed) as well as interest. Most borrowers, though, would refinance at this point.
Dignity mortgage: This is a new type of subprime mortgage with many moving parts. First, you make a down payment of about 10%. You’d also get a higher interest rate for a set period such as five years. If you’ve make timely payments to the end of that period, your interest payments reduce the overall mortgage balance. In addition, your interest rate switches to a more favorable prime rate.
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 mid-2000s.
Subprime mortgage lenders in part fueled the financial crisis that shook the globe between 2007 and 2008. Many of these lenders were handing out loans to people who couldn’t pay them back. As securing a mortgage became easier, more and more people jumped into the game. This led to rising home prices, which kept going higher and higher – and creating a bubble.
In addition, lenders started pooling loans into mortgage-backed securities before selling them to investors.
When hordes of borrowers defaulted on their loans, nearly everyone involved took a huge hit. People lost their homes, lenders lost their money, as did investors. The domino effect, along with other components of the financial meltdown, spread worldwide creating a global recession. But as the economy normalized, several types of subprime mortgages disappeared. And new ones have taken their place.
New Subprime Mortgage Rules
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 (CFPB) currently oversees subprime mortgages. One big change: subprime borrowers need to take part in homebuyer’s counseling led by someone approved by the U.S. Department of Housing and Urban Development (HUD) before obtaining 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 be aware of the risks involved with sub-prime mortgages. Also, be aware of your options.
Alternatives to Subprime Mortgages
If you haven’t owned a home in the past three years, there is likely a first-time homebuyer program you can benefit from. Specifically, you may qualify for a government-backed program that offers better rates and terms than subprime mortgages. These include 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 qualify. Find out more about USDA loans.
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.
Requirements for subprime mortgages are stricter now than they were before the housing bubble burst. For example, you will have to undergo homebuyer’s counseling to make sure you understand what you’re getting yourself into. Interest payments are high, particularly if your mortgage is for longer than 30 years. In fact, many people who get subprime mortgages do not plan on paying till the end of the loan term. Instead, they hope to improve their credit score and refinance to a better interest rate. Or maybe they want to sell for a profit before the end of the loan term. These are fine plans, but you should make sure they are doable before taking out a subprime mortgage.
Home Buying Tips
- Most real-estate agents will require you to have pre-approval for a mortgage before they work with you. You can use this mortgage pre-approval checklist to see if you will get the pre-approval you need.
- Home buyers may find it helpful to consult with a financial advisor. Finding the right financial advisor that fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in 5 minutes. If you’re ready to be matched with local advisors that will help you achieve your financial goals, get started now.
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