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Subprime mortgages are home loans for borrowers with low credit scores, often below 600, that prevent them from qualifying for a conventional loan. These usually carry higher interest rates and down payment requirements than conventional loans. Widely blamed for fueling the Great Recession, subprime mortgages now exist as nonprime mortgages under stricter rules, but they’re still risky, and generally not the best kind of loan to sign up for.
How do subprime mortgages work?
Synonymous with the Great Recession, subprime mortgages took on a new name following the financial meltdown in 2008. Nonprime mortgages, as they’re known today, are regulated by the Consumer Financial Protection Bureau (CFPB), which laid out new rules under the Dodd-Frank Wall Street Reform and Consumer Protection Act.
One of those rules: Before a lender can issue a subprime or nonprime mortgage, borrowers must undergo homebuyer counseling through a representative approved by the U.S. Department of Housing and Urban Development (HUD). In addition, lenders must underwrite subprime mortgages according to the standards set under Dodd-Frank.
Per CFPB rules, some subprime mortgages fall into a new non-qualified mortgage category. This designation limits legal protections for lenders, so they’re potentially risky for the lender, as well.
“Lenders aren’t making the same kinds of subprime loans that they did during the run-up to the Great Recession,” says Austin Kilgore, director of digital lending at Javelin Strategy & Research. “The biggest reason is regulatory issues.”
Subprime mortgage rules
Kilgore notes that the “ability-to-repay” (ATR) provision in Dodd-Frank requires lenders to undergo a thorough process to determine whether potential borrowers are capable of paying back the loan under the established terms.
“If you violate the ATR rule as a lender, you can potentially be sued or be subject to regulatory enforcement,” Kilgore says. “So lenders that operate in the non-qualified mortgage space have a strong incentive to make sure they are adequately evaluating borrowers much more than the subprime lenders of 15 to 20 years ago did.”
The CFPB periodically reviews the rules and makes changes when deemed necessary.
Dodd-Frank in general has also come under criticism by some. In 2018, Congress voted to roll back parts of the law. Although these changes didn’t erode or directly impact provisions to protect consumers from riskier subprime or nonprime mortgages, they did add another layer of uncertainty to an already risky loan.
Subprime mortgage risks
Because subprime mortgages are generally issued to borrowers with low credit scores, these loans raise risk for the lender. To make up for that risk, the lender might charge higher interest rates and fees than you might see on a conventional loan. Current 30-year fixed mortgage rates hover around 3 percent, but subprime mortgages can have interest rates as high as 10 percent.
|Home price||Down payment||Interest rate||Loan term||Monthly mortgage payment||Interest total|
|$200,000||20% ($40,000)||3%||30 Years||$674||$82,970|
|$200,000||20% ($40,000)||10%||30 Years||$1,404||$345,699|
Moreover, subprime or nonprime mortgages generally require larger down payments than their conventional counterparts. In the above scenario, a 20 percent down payment equates to $40,000 — but down payment requirements on subprime mortgages can climb to as high as 35 percent. In this example, that equates to $70,000.
Plus, terms on subprime mortgages can stretch longer than usual. Most conventional loans are designed to be paid off in 15 or 30 years, but some subprime mortgages can run the course of 40 or 50 years. The longer the term to pay off your mortgage, the more interest you’ll pay over the life of the loan. This could mean paying tens or hundreds of thousands more than you would if you had taken out a conventional 15- or 30-year mortgage.
Types of subprime mortgages
Subprime or nonprime mortgages function similarly to conventional mortgages. Here are some of the different types of subprime mortgages:
Subprime fixed-rate mortgage
A subprime fixed-rate mortgage works just like a conventional fixed-rate mortgage in that the borrower gets a set interest rate and the monthly payment remains the same for the length of the loan repayment period. The difference is that subprime fixed-rate mortgages sometimes have longer terms, such as 40 or 50 years, compared to the typical 15 or 30 years for a conventional fixed-rate loan.
Subprime adjustable-rate mortgage (ARM)
There are also subprime adjustable-rate mortgages, or ARMs, such as the 3/27 ARM, in which the borrower gets a fixed interest rate for the first three years, then the rate readjusts for the remaining 27 years. Rate adjustments are based on the performance of a market index plus a margin. Most lenders have a cap indicating by how much your rate can increase, but if you can’t make the peak monthly payment, you could be at risk of default.
With an interest-only loan, the borrower pays only interest during the first few years, typically seven or 10. This could mean smaller monthly payments at first, but no initial payoff of the loan principal, and delayed equity.
With a dignity mortgage, the borrower makes a down payment of at least 10 percent and takes on a high interest rate. If the borrower make timely payments for a certain period, typically five years, the amount paid toward interest gets used to lower the loan balance, and the interest rate is lowered to the prime rate, or the rate that most large banks charge their most creditworthy borrowers. This rate is largely determined by the federal funds rate set by the Federal Reserve. This type of mortgage can benefit you only if you can afford to make larger payments during the beginning of your term.
Should you get a subprime mortgage?
Probably not. Steep interest rates make subprime mortgages a loan of last resort.
The good news is that, even if your credit history is in tatters, a subprime mortgage isn’t your only option. Many government-backed mortgages — most notably FHA loans and VA loans — are designed to help borrowers with credit challenges. If you’re a first-time homebuyer, there are many first-time homebuyer assistance programs, as well.
Alternatives to a subprime mortgage
If you’re considering taking out a subprime or nonprime mortgage because of your credit history, know that it isn’t your only option. Many government-backed mortgages are designed to help those with less-than-favorable credit. They also tend to have lower interest rates than conventional loans.
- FHA loans: If your credit score is at least 580, consider an FHA loan with a down payment of 3.5 percent. If your credit score is between 500 and 579, you can qualify for an FHA loan with 10 percent down.
- VA loans: If you’re a veteran or active member of the armed forces, look into VA loans. Guaranteed by the U.S. Department of Veterans Affairs, these loans require no down payment and have no minimum credit score requirement.
- USDA loans: USDA loans are designed for low- to moderate-income borrowers in rural designated areas. (Some qualifying locations are near large metro areas.) While some lenders might have a credit score minimum for USDA loans, others might have relatively lenient standards that can help you qualify.
Subprime or nonprime mortgages are aimed at borrowers who may not have adequate credit to qualify for a conventional loan — but, they tend to come with higher interest rates and down payment requirements. In the long run, you could be paying much more than you would have with another type of loan. Before applying for a mortgage, consider improving your creditworthiness to qualify for a better rate and terms.
Regardless it is important to shop around and compare mortgage rates to find the best loan for your situation.
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