What Is a Subprime Mortgage? [Types & Eligibility Criteria]
Last Updated: February 2, 2023
When you apply for a mortgage, the lender considers your credit and financial history to determine which loan you’re eligible for. If you’re qualified for subprime, rather than a conventional loan, you might be wondering what is a subprime mortgage.
In this article, we’ll define subprime mortgages, discuss their different types, and explore the differences between prime and subprime mortgage loans. We’ll also give details about the COVID-19 aid targeted towards subprime mortgages.
What Is a Subprime Mortgage
A subprime mortgage is a type of loan given to borrowers who don’t qualify for a traditional prime mortgage. Instead of taking an installment loan, borrowers who are considered to be at higher risk of defaulting on the loan can take a subprime mortgage loan, which was created as a way to help people who don’t fit the traditional lending criteria get access to affordable home financing. The subprime mortgage loan definition includes several different types of subprime mortgages, which we’ll get into later.
There are a few reasons why someone may not be eligible for a prime mortgage. According to the Federal Deposit Insurance Corp (FDIC), you’ll fit the subprime mortgage criteria if you:
- Had at least two payments that were 30 days late in the last 12 months, or at least one payment that was 60 days late in the last 24 months
- In the past 24 months, you’ve experienced a judgment, foreclosure, repossession, or charge-off
- In the last five years, you’ve filed for bankruptcy
- Your debt-to-income (DTI) ratio is at least 50%
When it comes to this kind of mortgage, the term subprime refers to the borrowers’ credit score, and the interest rate for this type of loan goes as high as 8%–10%. Subprime mortgages with increased interest rates will often be imposed on borrowers with FICO credit scores below 640.
The interest rate is the most significant distinction between a regular and subprime loan. Because subprime borrowers pose a greater risk for the lender, the lender charges a higher monthly interest rate, meaning that you’ll eventually pay more for your home using a subprime loan.
Financial Crisis in 2008
To get a better understanding of the subprime mortgage crisis, we need to take a closer look at its cause. The industry received one of the hardest hits during the financial crisis in 2008 because many individuals took out NINJA loans—an acronym standing for “no income, no job, and no assets.”
No proof of income was required to obtain one of these mortgages, so a buyer could claim a yearly income of $150,000 without any documentation to back it up. Because the interest rates of the subprime mortgage were “teaser rates,” meaning they started low and rose over time, many NINJA borrowers defaulted when they couldn’t pay off the mortgage principal fast enough.
|DID YOU KNOW: After the 2008 financial crisis, subprime loans were regulated by the Consumer Financial Protection Bureau (CFPB). One of the CFPB’s crucial regulations is that any person receiving a subprime mortgage must undergo homebuyer counseling from a HUD-approved representative, as well as meet Dodd-Frank’s ATR criteria.|
Prime vs Subprime Mortgage
As this industry has seen a resurgence in popularity of late, since the definition of subprime mortgage has changed, many have been wondering whether a prime or subprime mortgage is better. However, there is no easy answer to this question, as it depends on individual circumstances. When evaluating your application, a lender will look at your credit score, credit history, and debt-to-income ratio (DTI) to assess your creditworthiness and the amount of risk you pose as a borrower.
Mortgage applicants are usually graded from A to F, with A grades going to individuals with excellent credit, and F scores to those unable to repay a loan. Prime mortgage rates go to A and B borrowers, whereas lower-rated mortgage applicants must accept non-prime loans according to the subprime mortgage definition if they want any financing at all. Let’s take a closer look at how subprime loans differ from the prime ones:
Higher Interest Rate
Subprime borrowers are thought to be of greater-than-average risk compared to prime borrowers, so lenders tend to charge a higher interest rate to protect themselves. For comparison, the average rate for a 30-year fixed-rate conventional mortgage is under 3% right now, but the rate on a subprime loan might be as high as 8% to 10%.
Larger Down Payment
If you’re taking out a subprime mortgage, you’ll usually need to put down a larger deposit than you would for a prime loan of the same amount. According to the subprime mortgage definition, the approximate down payment amount ranges from 25% to 35% of the loan’s sum.
Longer Repayment Periods
With a regular mortgage, the term is generally 15 to 30 years. Subprime loans, on the other hand, frequently extend the repayment period to 40 or even 50 years. As a result, you could spend a significant amount of time making monthly mortgage payments, with the amount of interest you pay throughout the term of your loan significantly increasing.
Adjustable Interest Rate
Fixed interest rates don’t change over the life of the loan, but many subprime loans have adjustable interest rates. The meaning of these rates for subprime mortgage borrowers is that they’re set for a certain period of time and then typically adjusted yearly, resulting in substantial increases in both monthly payments and overall interest.
Smaller Loan Amounts
As a subprime borrower, you’d probably be unable to borrow as much as prime mortgage borrowers can.
Subprime loans tend to have higher loan fees than prime-rate loans, such as late payment delinquencies and origination fees.
Although subprime mortgages are not the most ideal type of loan, if you’re new to credit, have a below-average credit score, or your credit history includes significant negative events, taking a mortgage subprime loan might be of great help, given the circumstances.
Types of Subprime Mortgages
As I’ve already mentioned, there are several distinct subprime mortgage types, including the following ones, each with its own set of benefits and drawbacks:
Fixed-rate subprime mortgages offer a fixed interest rate for the life of the loan, meaning that your monthly payments will never increase, even if the market interest rates go up. But unlike a traditional mortgage, which has a term of 15 or 30 years, fixed-rate subprime loans can last for 40 to 50 years.
Adjustable-Rate Subprime Mortgages
Under the ARM subprime mortgage loan definition, the meaning of adjustable-rate mortgage differs from the conventional one, due to the fact that it offers a low introductory rate that resets according to the market index it’s linked to. For example, with a 5/1 ARM, borrowers would pay an introductory rate for the first five years, after which the rate would reset one or more times during the remaining 25 years. Lenders usually limit how much the interest rate can rise.
Interest-only subprime mortgages allow you to pay only the interest on your loan for a certain period of time, usually for five or ten years, which can help keep your monthly payments low in the short term. However, you’ll eventually have to start paying back the principal subprime mortgage amount as well, meaning your monthly payments will probably experience a dramatic increase.
Dignity mortgages are a new type of subprime mortgage created in response to the financial crisis of 2008 and acting like a hybrid of the subprime and conventional mortgage. Borrowers must make a 10% down payment and accept a higher interest rate for the first few years—usually five. If they pay on time each month, the rate is lowered to the prime rate (the interest rate banks charge their most creditworthy clients) at the conclusion of the term.
Advantages and Disadvantages of Subprime Mortgages
There are a number of advantages and disadvantages to subprime mortgages. Some of the main advantages include:
- By definition, applicants qualify for a subprime mortgage even if they have bad credit histories or high debt-to-income ratios.
- Subprime loans can assist customers in improving their credit scores by paying off other debts first and then working towards making on-time payments on the mortgage.
- These loans can assist individuals who need to pay off other debts by pooling all the debt and making payments easier (you can also consult a debt-relief company)
- Government regulations limit how high the lender can set the interest rate.
- Subprime borrowers have greater opportunities to own homes, cars, and other things they wouldn’t be unable to fund on their own.
The main disadvantages of subprime mortgages include:
- Lenders face enhanced risk with subprime mortgage lending, which can result in higher interest rate for borrowers.
- The interest rate can go up at any time, making it difficult to afford your monthly payments.
- Borrowers are more likely to default on loans and damage their credit score further due to high interest rates.
- Because of the higher processing fees and upfront payments, some borrowers may find subprime mortgages difficult to afford.
|The meaning of the term subprime mortgage refers to the individual’s below-average credit score, implying they’re a credit risk.|
|The 2008 financial crisis has been linked to the increase in the number of subprime mortgages given to unqualified borrowers.|
|Subprime mortgages are characterized by higher interest rates, larger down payments, and longer repayment periods compared to prime mortgage loans.|
|There are several subprime mortgage types, including fixed-rate, adjustable-rate, interest-only, and dignity mortgages.|
COVID-19 Mortgage Relief
As the COVID-19 pandemic has caused many people to lose their jobs or have their hours reduced, the government has created a number of programs to help people who are struggling to pay off their subprime mortgage lending due to COVID-19. These programs include:
- The Coronavirus Aid, Relief, and Economic Security (CARES) Act, which was signed into law on March 27, 2020, provided some limited assistance to individuals who found themselves unable to fulfill their mortgage obligations owing to the initial financial consequences of the coronavirus epidemic.
- The Home Affordable Refinance Program (HARP) allows homeowners who are struggling to make their mortgage payments to refinance their loan at a lower interest rate.
- The Home Affordable Modification Program (HAMP) allows homeowners who are struggling to make their mortgage payments to modify their loan terms, which can help them keep their home.
These programs were designed for all homeowners who struggled to pay their subprime mortgage monthly rate or refinance it due to COVID-19. By consulting the National Low Income Coalition’s website, they were provided with a list of all the programs currently available, where they could learn about their eligibility for forbearance.
|DID YOU KNOW: The American Rescue Plan (ARP) Act of 2021, which President Biden signed into law, provided additional aid. The nearly $2 trillion coronavirus relief package included additional money that helped those who were behind on payments on their houses, rents, and utility bills.|
All things considered, subprime mortgages can be a helpful way to finance your home, although they come with certain risks. Before making your ultimate decision, be sure to research all your options and differentiate between a prime vs subprime mortgage so that you can find out which one you’re eligible for.
It all depends on your individual circumstances. If you have good credit and can qualify for a conventional mortgage, you’ll probably get a lower interest rate than with a subprime mortgage. However, if you have bad credit or are self-employed, a subprime mortgage may be the best option for you.
If you have a bad credit history, you’ll probably need to get a loan from a subprime mortgage lender. Although they typically charge interest rates higher than conventional lenders, if you understand what is a subprime mortgage, you might realize that it might be the only available option.
Subprime mortgages were first introduced in the early 1990s as a way to help people with low credit ratings buy homes. However, they became increasingly popular during the housing boom of the 2000s, when many people decided to take out subprime loans to buy their dream homes.