What Is a Subprime Mortgage

Anbarasan Appavu

Subprime mortgages are typically issued to borrowers with low credit scores. The lender does not offer a prime conventional mortgage because the borrower poses a greater-than-average risk of defaulting on the loan.

In order to compensate for the greater risk associated with subprime mortgages, lending institutions frequently charge a much higher interest rate on subprime mortgages compared to prime mortgages. Frequently, these are also adjustable-rate mortgages (ARMs), so the interest rate may increase at specified intervals.

What Is a Subprime Mortgage and How the Subprime Mortgage is both Advantages and Risky

• "Subprime" refers to a mortgage applicant with a below-average credit score, indicating that they may pose a credit risk.

• Typically, the interest rate on a subprime mortgage is high to compensate lenders for the risk that the borrower will default on the loan.

• Subprime mortgage is available to the borrowers having credit scores below 640 and negative information on their credit reports.

In large part, the 2008 financial crisis has been attributed to the proliferation of subprime mortgages offered to unqualified buyers in the years preceding the crisis.

New mortgages issued to subprime borrowers are subject to restrictions and must be properly underwritten.

You can also read our other article about How to Compare Mortgages and Buy New Home

Understanding About Subprime Mortgages

The term "subprime" does not refer to the interest rates usually attached to these mortgages, but rather to the borrower's credit score. Borrowers with FICO credit scores below 640 are frequently relegated to subprime mortgages with higher interest rates. Before applying for a mortgage, it can be beneficial for individuals with low credit scores to wait a period of time and build their credit histories, so they may qualify for a prime loan.

You can also read our other article about What Is Pre-Qualification?

The interest rate on a subprime mortgage depends on four factors: credit score, the size of the down payment, the number of late payment delinquencies on the borrower's credit report, and the nature of the delinquencies. A mortgage calculator is a useful tool for determining the impact of various interest rates on a monthly payment.

Different lenders will have different criteria for what constitutes a subprime loan, but historically, FICO scores below 640, 620, or 600 were considered subprime cutoffs.

Pricing for subprime mortgages can vary by mortgage type but nearly all share the following characteristics:

You can also read our other article about What Is an Adjustable-Rate Mortgage (ARM)?

High closing costs

Lenders offset a portion of the risk associated with lending to subprime borrowers by collecting hefty up-front fees. Subprime loans may have origination fees that are greater than 1 percentage point higher than conventional loans.

High interest

Subprime mortgage interest rates are typically several percentage points higher than conventional mortgage interest rates.

You can also read our other article about What Is Credit Application?

Types of Subprime Mortgages

There are numerous types of subprime mortgages, but these five are the most prevalent.

1. Interest-Only Mortgages

Consider how a conventional mortgage works for a moment. Suppose you obtain a 15-year mortgage with a fixed rate of interest. This means that for 15 years, you will make a fixed monthly payment that includes both principal and interest.

However, an interest-only mortgage requires you to pay only the interest for a set period of time, typically five, seven, or ten years. If you are paying only interest, your monthly payments will be significantly lower than those of a conventional mortgage, but only until the end of the interest-only period.

After the time period expires, you will be required to pay the loan balance plus interest. The catch is that you will not receive additional time to pay off your mortgage. Therefore, if you obtained a 15-year mortgage with a five-year interest-only period, you have ten years to repay the principal plus interest.

You can also read our other article about What Is a Floating Interest Rate

2. Dignity Mortgages

The dignity mortgage is a new subprime mortgage loan type. Similar to the original subprime mortgage, the interest rate is above average. After five years of on-time mortgage payments, the interest rate is lowered to the standard rate. And all "extra" interest payments will be applied to the principal balance. Your interest rate will then be identical to that of a conventional mortgage.

You can also read our other article about What Is Monthly Treasury Average (MTA) Index?

3. Negative Amortization Loans

Positive amortization should be the mode of operation for a mortgage. You pay both the interest and a portion of the principal, and the amount you owe gradually decreases. Your loan is amortizing; it is gradually disappearing.

Negative amortization is the opposite of positive amortization. You cannot pay enough to cover the interest, resulting in a monthly increase in the loan balance.

For instance, suppose you obtain a $150,000 mortgage with an interest rate of 7%. You'd pay $875 per month in interest (0.07/12 months x 150,000 = $875). Now, let's say your lender has agreed to allow you to pay only $500 per month, which means you leave $375 in interest unpaid each month. What is the fate of the $375? The amount is added to your loan balance, bringing it to $150,375. If this occurred every month for a year, your loan balance would be $154,500, and if it occurred for five years, it would be $172,500!

When a lender grants you a loan with negative amortization, you will have a period of time during which you pay only interest. But no lender wants your loan to increase indefinitely! Eventually, they will increase your monthly payments, and you will be responsible for paying the entire interest and a portion of the loan balance.

You can also read our other article about What Is Equated Monthly Installment (EMI)?

4. Balloon Loans

Think how the balloon works. A balloon begins with a narrow width, expands gradually as air is blown into it, and then puffs to its full size.

That sums up a balloon loan perfectly! When you obtain a balloon loan, you make very small payments over an extended period of time. Small payments, however, result in a larger loan balance, which is eventually repaid with a single large payment.

So, let's say you borrow $250,000 on a five-year balloon mortgage. Let's also assume that you pay $1,000 per month toward the loan balance. After five years, you will have paid $60,000 toward your loan, leaving you with a balance of $190,000. At the conclusion of your five-year loan term, you will make a single payment of $190,000.

5. Adjustable Rate Mortgages (ARM)

With a conventional mortgage, the rate of interest remains constant. However, adjustable rate mortgage (ARM) have variable interest rates, which can fluctuate significantly!

ARM always begin with a fixed-rate "grace" period, which some lenders refer to as a "teaser." You may have a teaser for two, five, or ten years in which you pay the same annual interest rate. Then, when the teaser period ends, your interest rate becomes variable. Your interest rate could be extremely low one year and extremely high the next.

ARM can pose a significant risk to borrowers. Since it is impossible for borrowers to predict whether the interest rate will increase or decrease, they could easily end up owing significantly more than they can afford. And if this occurred on a large scale, with millions of borrowers unable to repay their mortgages, a major economic crisis could ensue.

Subprime Mortgage versus Prime Mortgage

Applicants for mortgages are typically graded on a scale from A to F, with applicants with excellent credit receiving an A and those with no discernible ability to repay a loan receiving an F. A and B candidates are eligible for prime mortgages, whereas lower-rated candidates must typically settle for subprime loans, if they can obtain loans at all.

Lenders are not legally required to offer you the best mortgage terms or even inform you that they are available; therefore, you should first apply for a prime mortgage to determine if you qualify.

The interest rate of subprime mortgage is higher than the prime mortgage loan. Prime mortgage interest rates are the rates where the banks and other mortgage lenders are willing to lend money to borrowers with the best credit histories. Prime mortgages may have fixed or adjustable interest rates.

An Example - Subprime Mortgages Effect

The 2008 housing market crash was largely caused by widespread subprime mortgage defaults. Numerous borrowers received NINJA loans, an acronym derived from the phrase "no income, no employment, and no assets."

These mortgages were frequently issued without requiring a down payment or income verification. A purchaser could claim annual earnings of $150,000 but was not required to provide documentation to support the claim. In a declining housing market, these borrowers found themselves in negative equity, with their home values falling below their mortgage balances. Many of these NINJA borrowers defaulted because the associated interest rates were "teaser rates," variable rates that began low and ballooned over time, making it extremely difficult to pay down the mortgage principal.

Wells Fargo, Bank of America, and other financial institutions announced in June 2015 that they would begin offering mortgages to individuals with credit scores in the low 600s. In 2018, Neighborhood Assistance Corporation of America continued its Achieve the Dream tour, hosting events across the country to assist people in applying for "non-prime" loans, which are essentially the same as subprime mortgages.

Why subprime mortgage is the best option for me?

A subprime or non prime mortgage is an option for those with poor credit. You may also qualify for a mortgage backed by the government, such as a Federal Housing Administration (FHA) or Department of Veterans Affairs (VA) loan. These loans have looser requirements for credit score and down payment. Before pursuing a subprime mortgage, it is crucial to consider all of your options.

Know that non prime mortgages are not limited to borrowers with poor credit. Certain condominiums and log homes, for example, are ineligible for conventional mortgages. Self-employed individuals with a modest amount of taxable income may also qualify for a subprime mortgage. The same holds true for foreign nationals without a credit history in the United States.

Advantages and Risks of Subprime Mortgage

One of the greatest advantages of subprime mortgages is that they provide a means to obtain home financing for those who do not otherwise qualify.

Subprime Mortgage Advantages

When most financial institutions check the credit scores and financial histories of their borrowers in depth, many borrowers lose access to prime loans. In addition, not everyone will have sufficient assets or a spotless financial history, which the majority of banks consider before approving a loan.

·       These borrowers can access the subprime lending market in such circumstances. In the subprime market, anyone who is not eligible for a prime loan can obtain credit, albeit at a significantly higher interest rate. In subprime markets, credit scores are not required to obtain a loan.

Subprime lending can be viewed as an excellent way to maintain or improve one's credit score. However, unpaid debts can have a significant impact on a person's credit score, and those with such debts in their credit history are ineligible for a prime loan.

·                    In such situations, a borrower can opt for a loan that does not require a high credit score and use the funds to pay off debts he previously found challenging to repay. This loan can be repaid in the coming years, decreasing the borrower's likelihood of acquiring a poor credit rating. Therefore, subprime borrowing is an excellent way to improve a borrower's credit score.

Even though you have the eligibility and subprime mortgage is available to you, it does not mean you should obtain one. While there are a few advantages, there are also a number of risks to consider:

Subprime Mortgage Risks

Higher rates: 

Subprime mortgage borrowers typically have low credit scores and other financial difficulties, which results in higher interest rates. Therefore, it is significantly riskier for a lender to provide this type of loan than a conventional mortgage. To compensate for this risk, lenders charge higher rates of interest. Currently, the average rate for a conventional 30-year fixed-rate mortgage is below 3%, while the rate on a subprime mortgage can be as high as 8% to 10% and requires larger down payments.

Larger down payment: 

Some lenders also offset the risk of subprime mortgages by requiring larger down payments, ranging from 25 to 35 percent, depending on the type of loan. This can be challenging if home values are rising rapidly and you risk being priced out of the neighborhood of your choice. You must also avoid investing too much of your liquid savings in your home. In the event of a financial emergency, you must have sufficient savings to cover expenses, such as your mortgage payment.

Higher payments: 

Due to the likelihood that you will be required to pay a higher interest rate on a subprime mortgage, your monthly payments will be higher. Obviously, you shouldn't borrow more than you can afford to pay back, and lenders will verify this. However, if your financial circumstances change — for example, if you lose your job or have a medical emergency — those high payments may become unmanageable. Missing mortgage payments can severely harm your credit, or even result in foreclosure.

Longer terms:

Typical conventional mortgage terms range between 15 and 30 years. In contrast, subprime mortgages frequently extend the repayment period to 40 or even 50 years. So you could spend a significant portion of your life making mortgage payments. However, the amount of interest you pay over the life of the loan will increase significantly.

How the Subprime Mortgage is Classified by Borrower?

Lenders have their own risk assessment methods for borrowers. Essentially, they assign each prospective borrower a "grade" that represents the borrower's risk level. The highest grade is a "A-paper," which typically indicates that the borrower possesses all of the following:

• A credit score specified by the subprime mortgage lender  

• A debt-to-income ratio of no more than 35% - to check with lender

• A down payment of normally 20% - to check with lender

• Evidence of income and assets

If you have an A-paper, you will not qualify for a subprime mortgage. You will obtain a conventional mortgage, also known as a prime mortgage, with a fixed interest rate that is significantly lower than that of a subprime loan.

If you do not earn an A, you will receive a B, C, or D on your paper. A B paper is riskier than a C paper, and a C paper is riskier than a D paper. You have the concept.

However, all remain subprime mortgages and are issued to borrowers with the following characteristics:

• A credit rating less than 660

• Difficulty paying monthly living expenses

• Debt-to-income ratio of at least 50%

• Bankruptcy within the past five years

• Foreclosure within the past two years

Whether Getting Subprime Mortgage Loans is Bad?

The housing market has strengthened significantly since 2007. But did we learn from our mistakes? Not exactly, no. Subprime mortgages have recently made a comeback. These revived subprime mortgage loans are given new names, such as the dignity mortgage, by lenders. Despite the new moniker, the mortgage is still risky and carries a higher interest rate.

If you are considering obtaining a subprime mortgage, ask yourself the following three questions.

Are you truly prepared to purchase a home?

Certainly, you may be mentally prepared. However, if you are not financially prepared, you should not obtain a mortgage, subprime loan or not. Remember that you want to own your home, not be owned by it. If you need a mortgage to purchase a home, ensure that you have the following in place:

• You have three to six months of expenses saved in an emergency fund • You have no outstanding debt

• You have saved at least 10–20% of the down payment (20% is ideal to avoid private mortgage insurance (PMI) payments)

 • Your mortgage payment does not exceed 25% of your net income.

If you have not addressed these fundamentals, you are not ready to purchase a home. And despite the fact that you could technically qualify for a subprime mortgage, you are borrowing more than you can safely repay and putting yourself in a financially precarious position.

Do you wish to take the additional risk?

Be truthful with yourself. What makes you believe that you can repay your debts now if you have not done so in the past? If you start missing payments, your lender will not hesitate to foreclose on your home. And if you thought it was difficult to purchase a home with poor credit, try doing so after a default!

There's nothing wrong with renting, especially if you want to gain experience making on-time monthly payments. You can save money for your down payment, gain confidence, and improve your track record of on-time payments.

Do you truly desire to pay that much more for a home?

On the surface, subprime mortgages appear to be a noble effort to help the poor obtain housing.

However, a closer examination of this mortgage reveals that you are actually paying more for a home. And by more we mean significantly more money for your home. You incur a higher interest rate, higher closing costs, and, in the majority of cases, a longer loan repayment period. Your lender is receiving an excellent deal. And you? Not at all.

Why Should Get a Subprime Mortgage?

As the term suggests, a subprime mortgage is subpar. Here are some situations in which you may want to consider getting one, and others in which you should think twice.

When Subprime Mortgage is the Best Choice:

• You have discovered a home that is a rare bargain that you cannot let slip away.       

• You are rebuilding your credit and are confident that you can afford the payments, both now and in the future.

• You anticipate remaining in the home for roughly a decade and refinancing. (This can be challenging in times of rising interest rates; while improving your credit could remove you from the subprime category in five to ten years, the lowest available rates by then may be comparable to those of subprime loans today). In contrast, rates could reach a peak and then begin to decline within that time frame.

• You intend to refinance with a larger down payment based on a reliably anticipated increase in income or available funds (for instance, if you expect an inheritance or will or plan to sell a real estate or other assets).

When Subprime Mortgage is Not a Good Choice:

• You can hardly afford the monthly payments with your current income.

• You are only eligible for an ARM and must stretch to make the initial payments. (This is the same issue as the previous point, but ratcheting ARM interest rates will exacerbate the problem.)

• You have the option of obtaining a cosigner with excellent credit who can help you qualify for subprime loan terms that are more favorable.

• You are on the verge of qualifying for a non-subprime loan, and you can take steps within the next six to twelve months to improve your mortgage readiness.

The Bottom Line

If you have a limited or spotty credit history, a subprime mortgage may be your best chance to purchase the home of your dreams. However, they come at a high cost, so prior to accepting one: 

• Shop around to get the perfect mortgage loan with a best interest rate.

• Carefully calculate the numbers to ensure you comprehend the true cost of the loan.

• Ensure that you are confident in your ability to make the payments.

• Understand your options for potentially refinancing in the future for better terms.

Instead of obtaining a subprime mortgage, you may choose to investigate the factors that are dragging down your credit report and credit score. Given sufficient time, you could improve your credit to the point where a subprime mortgage is unnecessary.

Subprime Mortgage Loans - FAQs

What Subprime Mortgage Loan Mean?

Subprime loans are offered to individuals who do not qualify for prime-rate loans at a higher interest rate. Traditional lenders have frequently rejected subprime borrowers due to their low credit scores or other indicators that they have a reasonable chance of defaulting on their debt repayments.

What Is the Difference Between Prime Loan and Subprime Mortgage Loan?

Because subprime borrowers are riskier, subprime loans carry higher interest rates. The exact interest rate charged on a subprime loan is not determined in advance. Different lenders may not evaluate the risk of a borrower in the same way. This means that a borrower with a subprime loan can save money by shopping around. However, by definition, all subprime loan rates exceed the prime rate.

Who Provides Subprime Mortgage Home loans?

Although any financial institution could offer a loan with subprime rates, there are lenders who specialize in high-interest subprime loans. These lenders give borrowers who have difficulty obtaining low-interest rates access to capital for investments, business expansion, or home purchases. Moreover, the higher interest rates associated with subprime loans can result in tens of thousands of dollars in additional interest payments over the life of a loan.

What Drawbacks Subprime Mortgage Loans have?

Higher interest rates will always result in a more expensive loan over time, which may be difficult to service for borrowers who are already experiencing financial difficulties. On a systemic level, subprime loan defaults have been identified as a major contributor to the 2008-2009 financial crisis. As a result of the free-flowing capital following the dot-com bubble in the early 2000s, lenders are frequently viewed as the most culpable parties, as they granted loans to individuals who could not afford them. However, borrowers who purchased homes they could not truly afford also contributed.

Whether Subprime Lending Cause the 2008-09 Financial Crisis?

The majority of experts concur that subprime mortgages contributed significantly to the financial crisis. Regarding the subprime mortgage portion of the financial crisis, there was no single entity or individual at fault. Rather, this crisis involved the interaction between the central banks of the world, homeowners, lenders, credit rating agencies, underwriters, and investors.

Post a Comment

Post a Comment (0)