A subprime mortgage is a type of home loan designed for borrowers who have a low credit score and a higher risk of default. These borrowers may have a history of late payments, limited credit history, or high levels of debt. As a result, subprime mortgages come with higher interest rates and more restrictive terms than traditional (prime) mortgages.
The term subprime may sound familiar thanks to the subprime mortgage crisis. Prior to 2008, mortgage lenders had much looser standards for approving borrowers with poor credit scores and financial track records. These were also sometimes called no-doc loans because some lenders were not requiring documented proof of income.
Eventually, many of those borrowers defaulted on their loans. Between 2007 and 2010, foreclosures skyrocketed and banks lost tons of money, causing the government to bail out many big banks, while others merged or were sold through failure.
How do subprime mortgages work?
Subprime mortgages are structured similarly to prime mortgages. The borrower is required to make monthly payments that include both principal and interest, and the loan is secured by the property being purchased. However, the interest rates on subprime mortgages are typically higher than prime mortgages to account for the increased risk of default. In addition, subprime mortgages may have more restrictive terms, such as higher fees and penalties, shorter repayment periods, or higher interest-only payments.
Subprime mortgages are designed for borrowers with poor credit scores and negative items on their credit reports. Unlike prime borrowers, who have good credit and a strong financial track record, subprime borrowers are often considered higher-risk by lenders.
The process of obtaining a subprime mortgage is regulated by the Consumer Financial Protection Bureau (CFPB) and the Dodd-Frank Wall Street Reform and Consumer Protection Act, which was enacted in response to the subprime mortgage crisis. This regulation includes a requirement for subprime borrowers to undergo homebuyer counseling provided by a representative approved by the U.S. Department of Housing and Urban Development (HUD).
Additionally, lenders must underwrite subprime mortgages according to the standards outlined by Dodd-Frank, including the ability-to-repay (ATR) rule. This requires lenders to thoroughly evaluate whether a borrower is capable of paying back the loan. If a lender violates the ATR rule, they could be subject to legal action or regulatory enforcement.
The ATR rule and other regulations put in place by Dodd-Frank have led many lenders to avoid the subprime mortgage market, as it limits their legal protections. As a result, lenders are not making the same kinds of subprime loans they did prior to the Great Recession, but rather have a strong incentive to thoroughly evaluate borrowers before offering a subprime loan.
Who are subprime mortgage borrowers?
Mortgage applicants with poor credit scores and negative items on their credit reports are often considered subprime. Whereas, prime borrowers have good credit and a strong financial track record, so the lender is more likely to offer them a loan at a lower interest rate.
Today, financial institutions often use the term nonprime instead of subprime, but the meaning is the same. Generally, that’s defined as a borrower with a credit score of 660 or less. According to the Federal Deposit Insurance Corp (FDIC), a subprime borrower is also someone who:
- Had at least two payments that were late by 30 days in the last 12 months, or at least one payment that was late by 60 days in the last 24 months
- Experienced a judgment, foreclosure, repossession or charge-off in the past 24 months
- Filed for bankruptcy in the last five years
- Has a relatively high default probability, as evidenced by, for example, a credit bureau risk score (FICO) of 660 or below
- Has a debt-to-income (DTI) ratio of at least 50%
Home loans designed for these types of higher-risk borrowers are considered subprime or nonprime mortgages.
Types of subprime mortgages
Subprime mortgages can come in a variety of forms, including:
Fixed-rate mortgages
Fixed-rate subprime mortgages have an interest rate that remains the same for the life of the loan. This type of mortgage is ideal for borrowers who want a predictable monthly payment and want to avoid the risk of rising interest rates.
Adjustable-rate mortgages (ARM)
Adjustable-rate subprime mortgages have an interest rate that can change over time. This type of mortgage is ideal for borrowers who want a lower initial interest rate and are willing to accept the risk of higher monthly payments in the future.
Interest-only mortgages
Interest-only subprime mortgages allow the borrower to only pay the interest on the loan for a set period of time, typically five to ten years. This type of mortgage is ideal for borrowers who want to keep their monthly payments low but are willing to accept the risk of a larger payment when the interest-only period ends.
Dignity mortgages
Dignity mortgages are a type of subprime mortgage specifically designed for borrowers with poor credit. These mortgages typically have lower interest rates than other subprime mortgages but come with higher fees and more restrictive terms.
Risks of subprime mortgages
Subprime mortgages are generally considered riskier for both the borrower and the lender compared to conventional mortgages. This is due to several reasons, including the higher interest rates, adjustable rates, and the tendency of subprime borrowers to have a less-established credit history and income. Here are some of the key risks associated with subprime mortgages:
- Higher Interest Rates: One of the main reasons subprime mortgages are considered riskier is because they typically come with higher interest rates than conventional loans. This can make it more difficult for borrowers to afford their monthly payments and increase the likelihood of default.
- Adjustable Rates: Another factor that makes subprime mortgages riskier is that many of these loans have adjustable interest rates, meaning the interest rate can change over time. This can result in the monthly payment increasing significantly, which could make it difficult for the borrower to afford their mortgage.
- Foreclosure: If a subprime borrower defaults on their mortgage, they may face foreclosure, which can result in the loss of their home and damage to their credit score.
Alternatives to a subprime mortgage
For those who do not qualify for a prime mortgage, there are several alternatives to consider, including:
FHA loans
FHA loans are government-insured loans that are available to borrowers with lower credit scores and smaller down payments. These loans come with lower interest rates and more flexible terms than subprime mortgages.
VA loans
VA loans are government-insured loans specifically designed for veterans and their families. These loans come with lower interest rates and more flexible terms than subprime mortgages and may not require a down payment.
USDA loans
USDA loans are government-insured loans specifically designed for rural borrowers. These loans come with low interest rates and may not require a down payment.
Subprime vs. prime mortgage
A subprime mortgage is a type of home loan designed for borrowers who have a low credit score and a higher risk of default. In contrast, a prime mortgage is a traditional home loan designed for borrowers with good credit and a lower risk of default. Prime mortgages come with lower interest rates and more favorable terms than subprime mortgages.
What’s needed to get approved
To be approved for a subprime mortgage, borrowers typically need to meet the following requirements:
- Proof of Income: Lenders will want to see proof of your income in order to ensure that you have the ability to repay the loan. This may include pay stubs, tax returns, or other forms of income documentation. Your income is a critical factor in determining your debt-to-income (DTI) ratio, which must be below a certain threshold in order for you to be approved for a subprime mortgage.
- Proof of Employment: In addition to proof of income, lenders will want to see that you have a stable source of employment. This may include a job offer letter or recent pay stubs. Having a stable job will give lenders confidence that you have a reliable source of income, which is key when evaluating whether you will be able to repay the loan.
- Good Debt-to-Income (DTI) Ratio: Your debt-to-income ratio compares the amount of debt you have to your monthly income. Lenders use this ratio to evaluate your ability to repay the loan. In general, a good DTI ratio is considered to be below 50%. For subprime borrowers, the DTI ratio will typically be higher, but it must still be within a manageable range in order for you to be approved for a loan.
- Sufficient Down Payment: Subprime borrowers will typically be required to put down a larger down payment than prime borrowers. This down payment serves as collateral for the loan and helps to offset some of the risk that the lender is taking by lending to a high-risk borrower. Depending on the lender and the loan type, the required down payment may be as much as 20% of the purchase price of the property.
- Adequate Collateral (Property): In order to obtain a subprime mortgage, you must have a property that will serve as collateral for the loan. This property must be appraised in order to determine its value, which will then be used to determine the amount of the loan that you are eligible for. The value of the property must also be sufficient to cover the loan in case of default, so lenders will typically require that you have a property that is in good condition and has sufficient equity.
Are subprime mortgage loans bad?
While subprime mortgages come with higher interest rates and more restrictive terms, they can be a good option for borrowers who do not qualify for prime mortgages and need a way to purchase a home. However, subprime mortgages can also be risky for borrowers who are unable to make the monthly payments, leading to default and negative consequences for their credit score.
