Bad Credit Series: What Is a Subprime Mortgage?

If you’re tired of renting and lining someone else’s pockets with your monthly payments, you might be ready to purchase a home. The question is, how ready are you? Sure, you pay your rent on time every month, but does that mean you can make a mortgage payment? And if your credit is less than perfect, that can seriously impact whether a lender is willing to loan you tens or hundreds of thousands of dollars.

Enter the subprime mortgage market. These loans carry varying degrees of risk, so they come at a cost. But if you’re smart and make wise decisions, you can use a subprime loan as a springboard to a conventional loan.

What Does Subprime Mean?

Subprime literally means below prime. You’ll pay more, and your loan underwriting requirements might be more stringent than those for borrowers with conventional loans. But lenders are also taking on a greater risk in loaning you money because of a less-than-stellar credit score. The trade-off for the risk is more hoops to jump through and a higher price for the privilege of jumping through them.

What Is the Prime Rate and Why Does It Matter?

The prime rate is the interest rate a lender charges its most creditworthy customers. This rate is typically only available to commercial clients. But it is also the benchmark lenders use to determine how much their customers are going to have to pay for a loan, whether that’s a mortgage, a personal loan, or a small-business loan. Many mortgage interest rates are based on prime plus a margin determined based on borrower risk.

Who Qualifies for a Subprime Mortgage?

To qualify for a conventional mortgage, a borrower typically needs a credit score above 680 and a minimum down payment of 5 to 10%. But with a subprime loan, the requirements are a bit more relaxed. Most subprime borrowers have lower incomes and credit scores as low as 500. Down payment requirements vary, from no money down (though these are rare) up to 25%-35% of the price of the home. In short, if your credit score is below the conventional loan requirement, you most likely will be presented with subprime loan offers.

Types of Subprime Mortgages

There are several types of subprime mortgages, each of which offers benefits and also carries risks. Before signing on the dotted lines for one of these loans, you’ll want to understand how each loan works and what your requirements will be.

No Money Down

This loan was very popular before the mortgage meltdown. Basically, as long as the home the buyer was purchasing was worth the amount they needed to borrow to purchase it, most charges were rolled into a single loan. In some cases, outside programs provided grant money to effectively do the same thing, while creating a small amount of equity for specially qualified buyers, but this varied heavily from state to state. Some of these grant programs still exist, helping home buyers find their way home more easily.

Balloon Loan

With this loan, the first few years of your loan will offer lower mortgage payments, but after the agreed upon period of time (generally three to ten years) a large payment is due in order to pay off the mortgage. If you choose a loan with a balloon, start working on an exit strategy at least a year before your balloon payment is due.

Negative Amortization Loans

A negative amortization loan allows borrowers to pay part of the interest payments for a set amount of time. The balance of the interest is added to the principal of the mortgage. In many cases, this resulted in the principal growing to more than the original mortgage amount. When you owe more than you borrowed, that is negative amortization.

Adjustable-Rate Mortgages

Adjustable-rate mortgages (ARMs) have been around for a long time. The modern version of this loan, the hybrid ARM, offers a low payment with a fixed interest rate for the first few years of the loan, followed by adjustable-rate payments for the duration of the loan. For example, a 3/27 ARM means the first three years of a 30-year mortgage have a fixed interest rate, creating a stable principal plus interest (P + I) payment. At the start of year four, the payment will adjust yearly due to changes in the interest rate. The rate is set according to a financial index (such as LIBOR) and a margin. The margin is a predetermined figure that was agreed upon when the loan is originated.

Fixed-Rate with Extended Terms

Most conventional mortgages are for terms between 15 and 30 years. But an extended-term fixed-rate mortgage might stretch out the payments for 40-50 years. The end result is a lower monthly mortgage payment but much higher interest costs.

Interest-Only Loans

For a set period of time, usually three to seven years, the mortgage payment is made on the interest only. The principal is not touched, but at least the interest isn’t causing the loan amount to increase.

Dignity Mortgage

With a dignity mortgage, borrowers are required to make a 10% down payment toward the property purchase. Then for a period of normally five years, the payments are made with a higher interest rate. If at the end of the five-year period the mortgage is current and there were no late payments, the extra interest payments are applied to the principal amount of the loan and the interest rate drops to a prime level.

Qualifying Now Versus Then

Before the housing bust in the mid-2000s, qualifying for a subprime loan was almost easier than getting a conventional loan. Between no-money-down options and adjustable rates, almost anyone could end up in a huge home with a decent mortgage, at least for the first few years. It was when many of these subprime loan payments started to adjust that the housing crisis began.

After the dust settled and the majority of subprime lenders were out of business or reeled in, banks and other lenders went to the other extreme and made qualifying for a home loan an even more stringent process than it had been previously. The good news is that even if you have less than perfect credit, many of the subprime options still exist today so getting a mortgage is not out of the question. It’s just not the walk in the park it once was.

Subprime Loans Do Serve a Purpose

Although some lenders went out of their way to write ridiculous mortgages knowing people didn’t have the means to pay them, subprime loans do serve a purpose today. If you have little or no credit, or your income is low but you anticipate that it will increase dramatically, taking out an ARM or an interest-only mortgage is not a bad idea. After the introductory period, if your payments have been on time and your income has increased, you can either continue with the higher payments or refinance to a conventional mortgage. Whatever the circumstances, a subprime mortgage can be the solution for many who desire to own a home.