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subprime mortgage

A subprime mortgage is a type of home loan issued to borrowers with low credit scores (often below 600) who wouldn’t qualify for conventional mortgages. They usually come with much higher interest rates and down payments than conventional options. Taking out a subprime mortgage is rarely a good idea. You may be better off working with a financial advisor to rebuild your credit before applying for a subprime mortgage. But if it’s your only option, there are some points 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 their counterparts with higher credit scores. After all, would you be likely to loan money to someone with a habit of missing payments and borrowing more than he or she can pay back? That’s what runs through the heads of bankers and other mortgage lenders when they deal with subprime mortgages. So to compensate, they issue these loans with higher high interest rates and down-payment requirements.

To put that into perspective, the average interest rate for a 30-year fixed-rate conventional mortgage hovers around 4.20%. Today, interest rates for subprime mortgages can climb to 10%. Remember, interest is the cost of borrowing money. So the higher the rate, the more you’ll pay overall 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 typically goes up to around 30%.

So if you landed a subprime mortgage for a $200,000 home. You better have at least $60,000 at hand.

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 2008.

Following the Great Recession, subprime mortgages exist a bit differently today and they undergo heavier regulations. But they still carry major risk. We’ll describe the kinds you can find below.

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 counter parts. 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 the long run. And a huge chunk of it would come from interest payments.

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 10 years. At the end of that term, you begin to pay off the principal (the initial amount you borrowed).

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 make timely payments at the end of that period, your interest payments reduce the overall mortgage balance. In addition, your interest rate switches to the prime rate, the kind most conventional loans follow.

Subprime Mortgage Risks and the Great Recession

subprime mortgage

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 2010. Many of these lenders were handing out loans to people who couldn’t reasonably pay them back. As securing a mortgage became easier, more and more people jumped into the game. This led to a housing shortage and an spike in home prices as well as the financing required to purchase a home.

In addition, several 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 and huge investments plummeted. 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. 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. Borrowers also need to take part in homebuyer’s counseling led by 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 be aware of the risks involved with sub-prime mortgages. Also, be aware of your options.

Alternatives to Subprime Mortgages

subprime mortgage

If you haven’t owned a home in the past three years, there is likely a first-rime homebuyer program you can benefit from.

You may also qualify for government-backed programs that may offer 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 fall into its radar. Look into USDA loans to see if you’re interested in applying for one.

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.

But if subprime mortgages remain your last resort, get some paper work ready.

Requirements for Getting a Modern Subprime Mortgage

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

  • Last two years of pay stubs or relevant documentation of self-employment income
  • Last two tax returns
  • Documentation of employment history
  • Evidence of additional income such as alimony checks
  • Paper trail of bills and other financial obligations
  • Bank and investment statements

The Takeaway 

If it sounds too good to be true, that’s because it is. Sometimes, that’s the case with subprime mortgages. Even though they exist under a new regulatory environment following the 2008 financial crisis, they still pose some risk. They are easier to get than conventional mortgages. But the trade off is higher interest rates, down payments, and long-term costs. However, you may be able to clean up your credit score so you can refinance at better rates. That’s a challenge. But it can be done.

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Photo credit: ©iStock.com/cglade,©iStock.com/praetorianphoto, ©iStock.com/andresr

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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