Subprime mortgages may allow borrowers with lower credit scores to obtain homeownership, but they will pay a steep price for the privilege, thanks to the higher risk to lenders.
There is hope for borrowers who raise their credit profiles through consistent, on-time payments: They can look into refinancing.
Here’s a deep dive into the subprime mortgage world.
What Is a Subprime Mortgage?
What constitutes a prime and subprime credit score can vary among lenders and organizations. A FICO® Score of 670 to 739 is considered prime, Experian says. The range of 660 to 719 is cited by the federal Consumer Financial Protection Bureau. In any case, borrowers in those ranges qualify for the lowest rates.
A subprime mortgage is a housing loan intended for borrowers who have a credit score lower than 670, in Experian’s view, and negative items on their credit reports. Experian regards subprime borrowers as those with a score of 580 to 669, or fair credit.
Borrowers with lower credit scores represent a greater risk to the lender; they are statistically more likely to have trouble paying on time. So subprime mortgages often come with higher interest rates and larger down payments to help protect the lender from the increased risk of default.
Subprime borrowers accept these terms because they cannot qualify for a conventional mortgage — one from a private lender like a bank, credit union, or mortgage company — with lower costs.
Subprime mortgages are different from government-backed loans for borrowers with low credit scores (such as FHA loans).
How Subprime Mortgages Work
The main difference between a mortgage loan offered to a prime borrower vs. a subprime borrower is cost. Borrowers go through the same rigorous underwriting process with a lender and must submit documentation to verify income, employment, and assets.
But in the end, a prime borrower is offered the best rates, while a subprime borrower with so-called bad credit has to put more money down, pay more in fees, and pay a much higher interest rate over the life of the loan. Subprime mortgages also are often adjustable-rate mortgages, which means the payment can go up based on market indices.
Subprime Mortgages and the 2008 Housing Market Crash
Subprime mortgages became popular in the 2000s as more high-risk mortgages were made available to subprime borrowers. In 2005, subprime mortgages accounted for 20% of all new mortgage loans.
It became possible for a lender to originate more of these high-risk mortgages because of a new financial product called private-label mortgage-backed securities, sold to investors to fund the mortgages. The investments masked the risk of the subprime mortgages within.
Home prices soared as more borrowers sought out the various subprime mortgages being offered. Rising home prices also protected the investors of mortgage-backed securities from losses.
When the housing market had passed its peak and borrowers had no viable option for selling or refinancing their homes, properties began to fall into default. In an attempt to reduce their risk exposure, lenders originated fewer loans and increased requirements for even good borrowers. This depressed the market further.
Financial institutions that had taken strong positions in mortgage-backed securities were also in trouble. Many of the largest banking institutions in the world filed for bankruptcy, and the world learned once again what stock market crashes are.
In response to the financial crisis, the Federal Reserve implemented low mortgage rates in an attempt to jumpstart the economy.
Subprime Mortgage Regulations
In the wake of the financial crisis, Congress passed the Dodd-Frank Act to reduce excessive risk-taking in the mortgage industry. It established rules for what qualified mortgages are, which gave lenders a set of rules to follow to ensure that borrowers had the ability to repay the loans they were applying for.
It also provided regulation of qualified mortgages, including:
• Limiting mortgages to 30-year terms
• Limiting the amount of debt a borrower can take on to 43%
• Barring interest-only payments
• Barring negative amortization
• Barring balloon payments
• Putting a cap on fees and points a borrower can be charged for a loan
Subprime mortgages are not qualified mortgages. Borrowers who seek non-qualified mortgage loans may include self-employed people who want a more flexible financial verification process, people who have high debt, and people who want an interest-only loan.
Types of Subprime Mortgages
The most common types of subprime mortgages are adjustable-rate mortgages (ARMs), extended-term mortgages, and interest-only mortgages.
• ARMs. Adjustable-rate mortgages have an interest rate that will change over the life of the loan. They often come with a low introductory rate, which then changes to a rate tied to market indices.
• Extended-term mortgages. A subprime mortgage may have a term of 40 or 50 years instead of the typical 30-year term. Add to this the higher interest rate, and borrowers pay much more for the mortgage over the life of the loan.
• Interest-only mortgages. Interest-only loans offer borrowers the ability to only repay the interest part of the loan for the first part of the repayment period. Borrowers have the option of not repaying any principal for five to 10 years. The annual percentage rate is typically a half a point higher than for conventional loans. Origination fees may be higher as well.
The “dignity mortgage,” a new kind of subprime loan, could help borrowers who expect to redeem their creditworthiness. The borrower makes a down payment of about 10% and agrees to pay a higher rate of interest for a number of years, typically five. After that period of on-time payments, the amount paid toward interest goes toward reducing the mortgage balance, and the rate is lowered to the prime rate.
Subprime vs Prime Mortgages
Subprime mortgages have many of the same features as prime mortgages, but there are some key differences.
| Subprime Mortgage | Prime Mortgage |
|---|---|
| Higher interest rate | Lower interest rate |
| Borrowers have fair credit, with scores generally between 580 and 669 | Borrowers have good credit, with scores generally from 670 to 739 |
| Larger down payment requirements | Smaller down payment requirements |
| Smaller loan amounts | Larger loan amounts |
| Higher fees | Lower fees |
| Longer repayment periods | Shorter repayment periods |
| Often an adjustable interest rate | Fixed or adjustable rates |
Because the lending institution is taking on more risk to lend to a subprime borrower, larger down payments are required, and they usually charge a higher interest rate.
Applying for Subprime Mortgages
Most conventional lenders require a minimum credit score of 620, but there are lenders out there that specialize in subprime mortgages.
Generally, applying for a subprime mortgage is much the same as applying for a traditional mortgage. Lenders will check your credit and analyze your finances. They will ask for proof of income, verification of employment, and documentation of assets (such as bank statements). They may also ask for documentation regarding your debts or negative items in your credit reports.
Mortgage rates for subprime loans will vary depending on the prime rate, lending institution, the home’s location, the loan amount, the down payment, credit score, the interest rate type, the loan term, and loan type. The rate is typically much higher than a prime mortgage’s.
A mortgage calculator can help you find out what your monthly payments will be with a subprime mortgage. Simply adjust your mortgage rate to the one quoted by a lender for your credit situation.
Alternatives to Subprime Mortgages
Subprime loans are not the only option for borrowers with fair credit scores. Borrowers with credit issues can also look at mortgages backed by the Federal Housing Administration (FHA) and the Department of Veterans Affairs (VA).
FHA loans have more flexible standards for borrowers than conventional loans. Though borrowers can obtain a mortgage with a credit score as low as 500 (assuming they have a 10% down payment), FHA loans are not considered subprime mortgages. Instead, FHA loans are government-backed loans that provide mortgage insurance to FHA-approved lenders to use if the borrower defaults on the loan.
For many borrowers with good credit and a moderate down payment, FHA loans are more expensive and don’t make sense. However, for borrowers with lower credit scores and smaller down payments, an FHA loan could be the best option.
VA loans have no minimum credit requirement, but instead, lenders review the entire loan profile. The VA advises lenders to consider credit satisfactory if 12 months of payments have been made after the last derogatory credit item (in cases not involving bankruptcy).
The Takeaway
Subprime mortgages allow borrowers with impaired credit to unlock the door to a home, yet with unfavorable terms as a lender mitigates risk.
Borrowers who improve their credit and get on more substantial financial footing can look into refinancing the home loan with a conventional lender like SoFi. SoFi also offers home loans at competitive fixed rates and with flexible terms.
SoFi’s help center for mortgages is a great resource for all things financing. When you’re ready, take a deeper look at what SoFi offers.
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