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When you apply for a mortgage, the lender examines your credit and finances to assess how risky of a borrower you are. Depending on the results of that examination, you might be eligible for a subprime mortgage rather than a conventional loan. Lightbulb Key takeaways.
What is a subprime mortgage?
For borrowers with lower credit scores, typically below 600, which prevent them from being approved for conventional loans, subprime mortgages, also known as non-prime mortgages, are available. Conventional loans are frequently available and typically have better terms, like lower interest rates.
One of the primary causes of the financial crisis that led to the Great Recession was subprime mortgages. Lenders approved a lot of subprime mortgages in the years prior to the economic collapse that borrowers couldn’t afford to pay back. In fact, a Credit Union National Association analysis of Home Mortgage Disclosure Act data found that roughly 30% of all mortgages originated in 2006 were subprime.
Despite the fact that subprime mortgages still exist and may be known as non-qualified mortgages, they are now subject to more regulation. Furthermore, compared to conventional loans, they frequently have higher interest rates and bigger down payments.
How do subprime mortgages work?
The Dodd-Frank Wall Street Reform and Consumer Protection Act, which was passed in response to the subprime crisis, established the Consumer Financial Protection Bureau (CFPB), an organization that is now in charge of regulating subprime mortgages.
Any borrower who obtains a subprime mortgage is required to participate in homebuyer counseling through a counselor who has been approved by the U.S. S. Department of Housing and Urban Development (HUD).
Additionally, lenders must carry out subprime mortgage underwriting in accordance with Dodd-Frank requirements, such as the “ability-to-repay” (ATR) requirement, which calls for a lender to carefully evaluate whether a borrower is capable of repaying the loan.
According to Austin Kilgore, director of Corporate Communications at financial company Achieve, “if you violate the ATR rule as a lender, you could be sued or be subject to regulatory enforcement.” As a result, lenders who work in the non-qualified mortgage market have much greater motivation to thoroughly assess borrowers than did subprime lenders 15 to 20 years ago. ”.
Additionally, that “non-qualified mortgage” designation reduces lenders’ legal protections, which has discouraged many from operating in the sector.
According to Kilgore, lenders aren’t making the same kinds of subprime loans that they did in the years leading up to the Great Recession. “The biggest reason is regulatory issues. ”.
Subprime vs. prime mortgage requirements
Prime mortgages are accessible to highly qualified borrowers who present little risk to lenders in comparison to subprime mortgages. When lenders advertise rates “as low as,” they usually mean that those rates are only available to borrowers who are eligible for prime mortgages and have credit scores of 700 and higher (those who can get a conventional loan).
The down payment needed for a prime mortgage (a conventional loan) can be as little as 3 percent or 5 percent of the cost of the home.
On the other hand, the interest rates on subprime mortgages can be significantly higher — greater than 10%. In order to avoid making a sizable loan to a borrower who poses a greater risk, lenders frequently request a larger down payment, ranging from 25 to 35 percent.
| Credit score | Down payment | Interest rate | |
|---|---|---|---|
| Prime mortgage requirements | 700+ | As low as 3% | 7% (as of October 2022) |
| Subprime mortgage requirements | > 560 | As much as 25%-35% | 10% or higher |
Subprime vs. prime mortgage example
Subprime mortgages carry a higher risk for the lender because they are given to borrowers with bad credit. The lender charges higher interest rates and fees than you might see on a conventional loan to cover that risk. You’ll end up paying significantly more overall for a subprime mortgage with a higher rate:
| Home price | Down payment | Interest rate | Loan term | Monthly payment | Interest total | |
|---|---|---|---|---|---|---|
| Prime | $400,000 | $12,000 (3%) | 7% | 30 years | $2,581 | $541,616 |
| Subprime | $400,000 | $100,000 (25%) | 10% | 30 years | $2,632 | $649,135 |
Types of subprime mortgages
Similar to a traditional fixed-rate mortgage, a subprime mortgage has a set interest rate and a fixed monthly payment that applies for the duration of the loan repayment period. Contrary to conventional fixed-rate loans, which typically have terms of 15 or 30 years, subprime fixed-rate mortgages can occasionally have terms of 40 years or more.
Subprime adjustable-rate mortgage (ARM)
There are also subprime adjustable-rate mortgages, or ARMs, like the 3/27 ARM, where the borrower receives a fixed interest rate for the initial three years, after which the rate adjusts once a year for the following 27 years. The adjustments are made based on a market index’s performance plus a margin. Most lenders have a limit on how much their rates can rise, but if you are unable to pay the highest monthly payment, you may be in default.
In the first few years of an interest-only loan, usually the first seven or ten, the borrower only pays interest. This could result in lower initial monthly payments, no initial repayment of the loan principal, and delayed equity growth.
A dignity mortgage requires a minimum 10% down payment and a high interest rate from the borrower. The loan balance is reduced and the interest rate is lowered to the prime rate, or the rate that most large banks charge the most creditworthy borrowers, if the borrower makes on-time payments for a set amount of time, typically five years. (The Federal Reserve’s federal funds rate, which is a major factor in determining this rate, If you have the financial means to make larger payments at the beginning of your term, this type of mortgage might be advantageous.
Alternatives to a subprime mortgage
Another alternative is to simply wait. Continue paying your bills on time, and concentrate on making important credit-improving moves. You might want to purchase a home right away, but you also don’t want to be forced to pay a rate of interest that is excessively high.
Is a subprime mortgage right for me?
A nonprime mortgage isn’t the best option because you’ll pay more interest overall and possibly need to make a sizable down payment. However, if this mortgage is your only option for becoming a homeowner, it might be worth it despite the drawbacks. Consumer protections are stronger today than they were in the mid-2000s subprime go-go era.
