Definition, How They Work, Pros & Cons

  • Borrowers may be offered a subprime mortgage their FICO credit score falls below 670.
  • Subprime mortgages come with higher interest rates and fees, reflecting greater risk to lenders.
  • Alternatives to a subprime mortgage include FHA, VA, or USDA loans if you qualify.

Not all borrowers qualify for a regular or “prime” mortgage loan, typically due to some form of credit impairment. If a lender considers you to have a greater risk of default than other borrowers, you might qualify for what is known as a subprime mortgage.

Because of their role in the 2008-2009 financial crisis, subprime mortgages have a less than stellar reputation. It’s important for would-be borrowers to understand how subprime mortgages work and how to self-evaluate before agreeing to take one out.

What is a subprime mortgage? 

A subprime mortgage is an alternative offered to borrowers with low credit scores or other credit issues that disqualify them for a conventional mortgage. Because a subprime borrower is seen as a greater risk of not paying off their loan, they are required to pay a higher interest rate, which makes the mortgage more expensive than it would have been otherwise.

Subprime mortgages are perhaps best known for their role in helping to create the housing bubble that led to the financial crisis of 2008-2009 and the Great Recession of 2007-2009. These high-interest, low down-payment loans were part of an overall effort by the Federal Reserve to boost the economy in 2003. When the bubble burst many homeowners found themselves “underwater” with mortgage balances greater than the value of their homes.

Because of their role in the financial crisis, subprime mortgages have a negative connotation. Lenders have begun using the term “non-prime mortgage.” A non-prime mortgage could be thought of as a “new and improved” version of the old subprime mortgage. The main difference between the two is that non-prime mortgages are subject to tougher, more responsible underwriting. 

This allows people who can demonstrate their ability to keep up with house payments, but who have suffered a recent financial loss or tragedy, the opportunity to own their own home.

How do subprime mortgages work? 

Although there is no one-size-fits-all number, generally speaking, a borrower with a FICO credit score below 670 may be forced to take out a subprime mortgage loan. According to credit reporting agency, Experian, about 30% of U.S. consumers have a subprime credit score. 

Some of the factors that have a negative impact on a borrower’s FICO credit score leading to subprime status are:

  • Missed payments on credit accounts
  • Charge-offs, repossessions or foreclosures
  • Recent bankruptcy
  • High debt-to-income ratio
  • New to credit with no credit score

The interest rate associated with a subprime mortgage is dependent on four factors: credit score, the size of the down payment, the number of late payment delinquencies on a borrower’s credit report, and the types of delinquencies found on the report.

“Often, consumers don’t comprehend the risks of the financial products they’re signing themselves up for,” says Jeffrey Zhou, CEO of Fig Loans.

“The Consumer Financial Protection Bureau, a regulating body of Dodd-Frank, ensures that lenders offer appropriate financial products and loan terms that don’t financially hurt the consumers in the long run,” Zhou says. “Without the Consumer Financial Protection Bureau, lenders could offer borrowers excessive interest rates or overpriced financial products, making their financial situation worse. In short, it protects consumers from falling into the trap of possible lifetime debt from bad lenders and oversees financial activities in many financial industry segments.”

Types of subprime mortgages

There are four main types of subprime mortgage. In addition to the unique features of each type of loan, most have interest rates and fees than than traditional prime mortgage loans.

  • Fixed-rate: The interest rate remains constant for the entire duration of the loan. These loans also often last longer than a prime mortgage loan, which typically lasts 30 years. A fixed-rate subprime mortgage loan can extend up to 50 years.
  • Adjustable-rate: This type of loan often features a constant (fixed)  interest rate for a set period that later becomes a variable rate based on market conditions.
  • Interest-only: An interest-only mortgage loan lets borrowers pay only the interest portion during the early years of the loan. At a set period, payments increase to cover principal as well as interest.
  • Dignity mortgage: With this type of loan, borrowers must deposit a 10% down payment and agree to a higher interest rate for a set number of years — five is typical. If the borrowers make on-time regular payments, the interest rate reduces until it reaches the prime rate.

Who offers subprime mortgages?

Following the subprime mortgage crisis, subprime lenders all but disappeared from the scene. They have since reappeared, largely rebranded as non-prime or non-QM (non-qualified mortgage) lenders. Fortunately, if you do not qualify for a prime mortgage loan, resources exist to help you find and identify vetted non-prime lenders near you.

For starters, check your credit report and credit score. You will need the score to eliminate lenders who would otherwise eliminate you. Check with trusted local banks and mortgage lenders who offer prime rate mortgage loans. Many traditional lenders also offer subprime (non-prime, if you prefer) mortgage loans.

Consider lenders that specialize in subprime mortgage loans. Among the best known are Sprout Mortgage, Angel Oak, Carrington, and Athas Capital Group. A quick online search using terms such as “subprime, non-prime,” or “non-QM” mortgage loans should yield results. Finally, apply. The best way to find out if you qualify, is to apply for a loan or preapproval.

Should I get a subprime mortgage?

Just because you can get a subprime loan doesn’t mean you should. If you don’t qualify for prime mortgage now, the best thing to do is to get there. This requires work rebuilding your credit, paying off debt, saving for a higher down payment, all things that will raise your credit score and your chances of scoring a lower-interest mortgage loan.

If time, or patience, is not on your side, consider the pros and cons of a subprime loan and let that help guide your decision. First and foremost, if you’re not where you want to be credit-wise, a subprime or non-prime mortgage will put you in a home of your own, albeit at a higher interest rate, higher fees, and longer terms than if your credit score was higher.

“Have an exit plan,” advises Joshua Massieh, host at The Trading Fraternity. “Come into the transaction already thinking about how to refinance out of the loan or a timeline of when you are planning on selling the home.”

If you can consistently make house payments, your credit score will get a boost. On the other hand, all those fees and a high interest rate means higher payments and an increased risk of default on the loan.

Although you will pay a higher interest rate with a subprime loan, the sky is not the limit. The government caps interest rates on subprime mortgage loans and lenders have to honor those caps.

Ultimately, however, a subprime, non-prime, or non-QM mortgage loan costs more, both in the short-term and in the long-term. If you can resign yourself to that, a subprime loan might be for you.

Subprime mortgage alternatives

Before you get into a subprime loan, consider the alternatives.

“Don’t think that you’re choiceless,” says Zhou. “There are other and even better options than settling for a subprime mortgage. You can qualify for a homeownership assistance program if you don’t meet the credit requirement. So don’t lose your hope of owning a home.” 

Some alternatives include:

  • Federal Housing Administration (FHA) loans: FHA loans feature lower interest rates than conventional mortgages. You may be eligible for an FHA loan with a credit score as low as 500 with a 10% down payment or 580 with a 3.5% down payment.
  • Veterans Affairs (VA) loans: VA loans are available to qualified veterans or members of the military community, such as a spouse or beneficiary. You may be able to purchase a home with little or no money down with a VA loan.
  • U.S. Department of Agriculture (USDA) loans: There is no down payment requirement for a USDA home loan. If your income is limited and you want to purchase a home in an eligible rural area, you may qualify for this type of loan.

Subprime mortgages aren’t for everyone. If you’re not in a rush for housing, it’s probably better to improve your credit and qualify for a prime loan. If you don’t have time to wait, look into one of the alternatives listed above. 

If you decide (or are forced) to consider a subprime loan, it’s not all bad news according to Massieh.

“Lenders are still qualifying you on some sort of income which gives them the confidence to lend you the money to close on the transaction,” he says. “The lender’s confidence in you should also give you added support that this loan is a good idea for you since you have probably been denied from the larger banks and for conventional loans.”

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