What Are Subprime Mortgages?

A subprime mortgage is a borrowing option that requires low credit ratings to access a loan. It is differentiated from a prime mortgage that requires high credit ratings. The lender may consider the borrower to fulfill the above-average risk of defaulting on a loan and, as a result, deny the conventional prime mortgage. A lender issuing a subprime mortgage often charges high-interest rates than prime loans to cover the expected default risks. Most subprime mortgages are adjustable-rate mortgages, meaning that the interest rates pegged on these loans can exponentially increase at certain times.


subprime mortgage

What Are Subprime Mortgages?

One of the factors which caused the rise and dramatic fall of the housing market in the United States was the use of a tricky lending program called subprime mortgages, which allowed people with low credit ratings to secure home loans. Subprime and nonprime mortgages are aimed at borrowers who do not have enough credit to qualify for traditional loans. They tend to be associated with higher interest rates and repayment requirements. Moreover, in some cases, mortgage brokers received incentives from lenders to offer subprime ARM ratings that earned compliantly (non-subprime) loans.


What Is The Minimum Score For Subprime Mortgages?

Subprime mortgages or home loans are prices, interest rates, and fees designed for high-risk borrowers, also known as subprime borrowers. These loans are aimed at borrowers with a credit history and a credit rating, indicating a high risk of their loan not being repaid. Subprime mortgage borrowers typically have a low credit rating of at least 600, which prevents them from qualifying for a conventional loan.


Why Subprime?

It is a common misconception that the term “subprime” refers to the interest rate on a mortgage; in fact, it refers more to the credit history and the credit score of the borrower taking out the mortgage. For borrowers with a low credit rating (640 to 600, depending on the lender) or high credit risk, a subprime mortgage carries a higher interest rate and closing cost than a traditional loan. The interest rate associated with subprime mortgages is higher to compensate the lender for assuming the risk of a borrower defaulting.


Understanding Subprime Mortgages

As we mentioned, earlier the term subprime can be confusing when used in contrast to prime, which refers to the interest rate on a loan to the borrower. It sounds like a lower interest rate, but it actually means lower quality, which relates to the creditworthiness of the loans and not to a borrower. While it is clear that so-called “mortgages” from nonprime lenders have done much to distort credit classification since the 2007-2008 financial crisis, subprime mortgages still play an essential role.

Rating Factors

The term subprime refers to the credit score awarded to the prospective borrower taking the mortgage. If borrowers have a FICO credit score below 640, they are regarded as credit risky and can only qualify for subprime loans and their accompanying high-interest rates. Individuals under this category do well to work on their credit records before qualifying for prime mortgages. The interest rates charged on the subprime mortgage are dependent on several factors such as the size of the down payment, the credit score, the number, and the type of late payment delinquencies in the potential borrower’s credit report.


subprime mortgage

Types of Subprime Mortgages

Key takeaways banks offer high-risk borrowers home loans in the form of subprime mortgages to offset the risk of additional costs and higher interest rates. Home loans designed for these types of high-risk borrowers are classified as subprime or nonprime mortgages. Further, there are three types of subprime mortgages, as discussed below.


Adjustable-rate mortgages (ARMs)

A variable-rate mortgage (ARMS) is a home loan starting with a low fixed interest rate for three to ten years and is followed by regular rates of interest adjustments. An ARMS mortgage can be adjusted to change over the loan term, depending on the terms set at the time the loan is determined. A variable mortgage (ARM) is an interest rate that changes over the life of the mortgage.

ARMs begin with a relatively manageable interest rate called a tease. However, after a specific period, typically a year, the interest rate shifts to a floating rate pegged on published central bank interest. These fluctuating interest rates can increase considerably, putting a lot of pressure and unpredictability on households and home financing.

The two main advantages of an ARM mortgage are the low interest rates offered to borrowers and the flexible credit terms. An ARM is an intelligent financial choice for homeowners who plan to keep the loan for a limited period and can afford the potential increase in their interest rate. It is also a wiser financial decision if the homebuyer plans to repay the loan in full within a set time rather than suffer when interest rates are adjusted.


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Extended-term mortgages

Typically, conventional mortgages have a repayment period of thirty years; however, extended-term mortgages have between forty to fifty years. Their extended subprime mortgage interest rates also increase exponentially, costing tens or even hundreds of thousands in dollars throughout the loan’s life.

If you want to reduce the total amount of interest due and the total cost of borrowing over the term of your mortgage, then you should consider the option of overpaying to extend the term. A homeowner can qualify for a lower mortgage rate if his existing mortgage contains a monthly payment reduction that provides a compelling reason to extend the repayment period. For example, borrowers can secure a 15-year mortgage that they would otherwise struggle to afford if they could get monthly reductions on existing payments by refinancing it over a 30-year term.


Interest-only mortgages

An interest-only mortgage is a monthly interest payment on the amount borrowed during the initial term at a fixed rate. Interest rates on a mortgage loan do not decrease over the years unless the borrower makes additional payments to the capital. At the end of the term, the borrower can renegotiate the interest on the mortgage so that 1% is paid on the money or agree to convert the interest loan into interest payments and repay the loan if he has the option.

This type of subprime mortgage offers the borrower an opportunity to pay only interest during the first repayment period (often five to seven years) without including principal repayment. However, at the end of the introduction period, the borrower can begin repaying the principal by renewing the loan or refinancing it. The origination fees are often higher in this type of mortgage than the other subprime mortgages. Most borrowers who use interest-only usually resort to it for emergency purposes. Apart from the high interest and origination fee associated with it, interest-only borrowers are also at high risk of loss should they be forced to sell their houses in case of falling property values.


The Financial Crisis

Interest-only mortgages are so hard to come by because they contributed to the financial crisis of 2008, as borrowers couldn’t afford the surge in mortgage payments on ailing homes whose value was underwater. Low-interest loans are particularly vulnerable to borrowers whose house prices have fallen, making the mortgage higher than the house’s value. While some mortgages come with lower monthly payments when interest rates expire, rates are still higher than for other loans.


Higher Credit Quality

Standard interest-only mortgages include higher credit quality, more cash reserves and assets, and a higher household income than traditional interest-only loans, meaning that some monthly payments go into capital. Interest-only loans require higher payments, a lower leverage ratio, and good or excellent credit ratings (for example, a 700 FICO score or higher) compared to a typical interest-only mortgage. Interest-only loans are easier to sell to other financial institutions and more marketable because lenders can charge borrowers higher payments and higher interest rates than traditional loans, which are considered riskier.


subprime mortgage

How Does Subprime Mortgages Work?

Lenders define subprime borrowers according to their criteria and set their interest rate depending on prevailing risk factors. Different housing companies around the country have set their minimum creditworthiness score and use such to gauge a borrower. Therefore, it is essential for a potential borrower to carefully shop around the country to see which company has the best terms for mortgages and consumer credit. An individual can qualify for a conventional loan from one lender and permit only for a subprime loan in the other.

The pricing of subprime mortgages can differ from one lender to the other, but they all have similar characteristics.


High Cost

They will charge high costs on the mortgage to be offset by the borrower to help cover the risk of the loan. The processing cost is often high and is collected upfront during loan processing. The origination fee for subprime loans is also higher than conventional loans.


High Interest

The percentage interest assigned to a subprime mortgage is considerably higher than the prime mortgage by larger margins. The cumulative interest over the life of the loan can accumulate to tens of thousands of dollars.

An individual applying for a mortgage does not indicate whether they want a prime or subprime. The borrower will fill the loan form. The leader reviews the documents with the credit score, credit score, and other financial information to determine the type of loan the borrower deserves. The high-interest rates and exorbitant fees will tell the borrower they only qualify for a subprime loan.

Apart from the loan pricing, subprime mortgages work the same as all the other conventional mortgages. The lender assesses your ability to repay by reviewing your income, credit, savings, and other assets to determine how much subprime loan one qualifies to get. Depending on the type of subprime mortgage, the lender will expect a monthly repayment of interest and principal over a duration of time. Failure to repay the loan, the lender, exercises his right to take the house back and sell it to recoup the money lend to you.


Benefits Of Subprime Mortgages

The most common subprime mortgage is a variable rate mortgage, which is part of the affordable initial rate that moves to a variable rate tied to published central bank rates, such as the one-year London Interbank Offered Rate (Libor). Both subprime and nonprime mortgages require higher payments than their conventional counterparts. Subprime mortgages carry higher interest rates and closing costs than traditional loans for borrowers with a low (depending on the lender) or high credit risk.

In the mortgage business, borrowers with a poor credit rating are considered riskier and more likely to default than borrowers with a higher credit rating. While lenders take a borrower’s credit history into account when determining whether a loan is subprime, they also consider mortgage features such as the loan-to-value ratio and property characteristics that can cause a loan to be at an increased risk of default. Lenders have standards for determining risk categories by assessing the size of the proposed loan and taking into account how the repayment plan is structured. They categorize whether it is a traditional repayment loan, mortgage loan, endowment mortgage, interest-free loan, standard repayment loan, non-repayment loan, credit card limit, or other arrangements.


Credit Rating

The exact credit rating required to qualify for a subprime loan can vary from lender to lender. Still, generally, a score of 620 or higher should be considered. There is no official credit exclusion for borrowers, but people with credit ratings below 650 may find it harder to qualify for a conventional loan. Borrowers with a perfect credit score less than A-minus-B (paper A minus B) or C or D (paper D) are rated as A-minus-B (paper A minus B) or as interest payments by a reliable payer are increased, allowing the company to share the default risk with the borrower.


Government-Backed Mortgages

Many government-backed mortgages, FHA loans, and VA loans are designed to help borrowers with credit problems. Subprime loans were created to help poor people with little or no credit history qualify for loans that would help them buy a home or a car and finance other things they might not have been able to finance independently. Subprime loans allow people who are just starting to build up credit, become homeowners, or buy a car if they have not opted for a conventional loan.


Advantage

With a subprime mortgage, the borrower must pay interest, but it also allows him to increase his credit rating, pay off other debts, and plan to repay the principal. A fixed-rate subprime mortgage works like a traditional fixed-rate mortgage because the borrower receives a fixed rate, and the monthly payments for the duration of the repayment period remain the same.


subprime mortgage

Risks Of Subprime Mortgages

Since these loans are awarded to people who do not qualify for prime mortgages, the banks or lending institutions often charge a high interest rate to cover the default risk. These interest rates are also intended to encourage the borrower to pay their loans on time. The risk involved with these mortgages is that they are awarded individuals with issues with handling debts, making their lives more difficult.

Extended-term subprime mortgages add additional duration to the loan life, increasing the interest charged on the loan, making it difficult for the borrower to gain financial freedom. ARMs are subject to regular recalculation of the mortgage that makes it challenging to plan household expenditure.


Subprime Meltdown

Issuing of subprime loans could result in subprime meltdown as they once did during the great recession. Between 2004 to 2006, many lenders granted loans to many people leading to high capital liquidity. Since the loans were high-risk loans, they came with a high-interest rate above prime rates to help cover any default risks. The lenders then pooled the mortgages and resold them to investors to help fund the loans. The result was a housing shortage, as many people could now afford a mortgage. The increased demand resulted in rising housing prices.

The people awarded loans could not pay pack, leading to a high rate of housing foreclosures. The lenders lost their money, and so did the banks and the financial institutions who invested in the packaged mortgages. Some institution declared bankruptcy while other endured great financial distress. The meltdown underscored the most significant risk of subprime mortgages.

subprime mortgage

The Bottom Line

Banks and other financial lenders offer subprime mortgages to individuals whose credit record does not allow for a conventional or prime mortgage. They are usually accompanied by high process costs and interest rates to compensate for potential default risk. Apart from the high cost charged on loans, they work pretty much the same as other loans. However, they are risky in terms of default rates and could trigger a potential subprime meltdown if you don’t monitor them.

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Mydollarbillshttps://www.mydollarbills.com
Hi, we are Lena and Chris. A finance-addicted couple from Germany. Ever since we can remember we are interested in finance. We love to research and review complex topics. As we were quite familiar with the world of finance at all, we thought we should share this information with the rest of the world. Our main reason we do this is to help people to orientate themselves in the confusing daily finance puzzle.

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