What Is a Subprime Mortgage?

Updated: 11th Jan 2022 Written by Elijah Bishop
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If you are asking this question, you are either attempting to take out a mortgage with bad credit or have been offered a loan that falls into the category of a subprime loan. 

In this article, we’ll answer the question of what a subprime mortgage is and go over some of the risks and benefits that come with getting a subprime mortgage.

What Is a Subprime Mortgage? 

Subprime mortgages, also known as non-prime mortgages, are for consumers with credit scores below 600 who cannot get conventional loans. A conventional loan has a wider range of options and better terms, like lower interest rates.

Subprime mortgages were one of the significant factors behind the financial catastrophe that triggered the Great Recession. Before the financial crisis, lenders authorized many subprime mortgages that borrowers couldn’t pay back. According to a Credit Union National Association review of Home Mortgage Disclosure Act statistics, almost 30% of all mortgages originated in 2006 were subprime.

These days, subprime mortgages (also known as non-qualified mortgages) are subject to additional scrutiny. They also feature higher interest rates and down payments compared to conventional loans.

>> More: How to Buy a House with Bad Credit

How Do Subprime Mortgages Work? 

Like a conventional mortgage loan, a subprime mortgage is obtained through a mortgage lender, such as a bank or a mortgage company. The only difference between conventional and subprime mortgages is the interest rate. 

And since subprime borrowers pose a bigger risk to lenders, they often have to pay a higher monthly interest rate than conventional mortgage borrowers. More importantly, a subprime loan tends to cost more than a conventional mortgage loan in the long term.

What Are Subprime Mortgage Borrowers? 

Subprime mortgage borrowers are usually individuals with low credit scores or negative marks on their credit reports. Prime borrowers, in contrast, have good credit and a solid financial history, so lenders are more inclined to provide them with a low-interest loan.

Today, the term non-prime is now commonly used by lenders instead of subprime, but the connotation remains the same. The Federal Deposit Insurance Corp (FDIC) defines a subprime borrower as someone who:

  • Had two 30-day late payments in the last year, or one 60-day late payment in the previous 24 months
  • Charged off, experienced a foreclosure, repossession, or have had a judgment imposed on in the past 24 months. 
  • Bankruptcy in the last five years
  • Has a debt-to-income (DTI) of at least 50%

Subprime or non-prime mortgages are meant for higher-risk consumers. The subprime mortgage crisis may have made the word familiar. Before 2008, mortgage lenders had laxer requirements for admitting customers with bad credit. Some lenders did not require written proof of income, hence the name no-doc loans.

Many of those borrowers eventually defaulted. Between 2007 and 2010, the government bailed out many significant banks, while others merged or were sold through failure. The Dodd-Frank Act of 2010 overhauled financial regulation to prevent future crises in reaction to the subprime mortgage crisis. The act includes the ability-to-repay (ATR) rule for online mortgage lenders. This rule requires mortgage lenders to provide a rigorous process for evaluating borrowers’ ability to repay loans, thereby ending no-doc mortgages.

Lenders must also underwrite loans in accordance with Dodd-Frank. Violations of these rules may result in legal or regulatory action. Subprime borrowers must also attend homebuyer counseling given by a HUD-approved agent.

Types of Subprime Mortgages

While Subprime mortgages are available in many types, these five types of subprime mortgages are the most popular. They include: 

Interest-Only Mortgages

An interest-only mortgage allows the borrower to pay only the interest payable for the first five to seven years of the loan (without paying back principal). After this period, the borrower can renew or refinance the loan and start paying down the principal.

Interest-only mortgages have higher APRs than equivalent conventional loans, and mortgage origination fees are often greater than other subprime loans. Interest-only mortgages work best for borrowers who use them as a last resort. This allows them to routinely make full principal-and-interest payments and interest-only payments in months with unanticipated expenses. Borrowers who choose interest-only payments run a higher risk of losing money if forced to sell their homes during a period of low or declining property values.

Subprime Adjustable-Rate Mortgages (ARM)

Fixed mortgage interest rates remain constant. Adjustable-rate mortgages, on the other hand, have variable interest rates that can alter dramatically. A fixed-rate “teaser” period precedes all ARMs. You may have a teaser of two, five, or ten years with the same annual interest rate. After the teaser period, your interest rate may fluctuate. Your interest rate may be relatively low one year and very high the following.

ARMs can pose a severe risk to borrowers. Because borrowers can’t foresee whether interest rates will rise or fall, they may end up paying considerably more than they can afford. And if millions more borrowers were unable to pay their mortgages, we could face a massive economic disaster.

Subprime Fixed-Rate Mortgages

Like a conventional fixed-rate mortgage, a subprime fixed-rate mortgage has a fixed interest rate and a fixed monthly payment throughout the life of the loan. The tenure of a subprime fixed-rate mortgage can be 40 years, compared to 15 or 30 years for a normal fixed-rate loan.

Dignity Mortgages

A dignity mortgage requires a down payment of at least 10% and accepts a high-interest rate. In return for timely payments for a set length of time (usually five years), the interest paid is applied to the loan debt, and the rate is reduced to the prime rate, which is the rate most large banks charge the most creditworthy borrowers. (The Federal Reserve sets the federal funds rate.) This mortgage may be useful if you can afford higher payments early in the loan term.

Balloon Loans

Consider a balloon. A balloon begins small, progressively increases as you inhale air into it, then puffs to its full size. This also applies when you take out a balloon mortgage loan. A balloon loan requires long-term, small installments. Small installments increase your loan debt, and you must finally make one large payment to settle the entire loan.

Consider a five-year balloon loan on a $250,000 home. Assume you pay $1,000 each month on your loan. After five years, you must have paid off at least $60,000 of your loan, but then you still owe the lender $190,000. Once you exhaust the five years, you’ll need to pay the whole $190,000 in one lump sum.

What Are the Benefits of Subprime Mortgages? 

Below are the few advantages associated with getting a subprime mortgage:

  • Subprime mortgages enable people with bad credit to buy a home.
  • Since subprime mortgages only require the borrower to pay the interest, you can improve your credit score by paying off other debts before tackling the principal.

What Are the Risks of Subprime Mortgages?

Before taking out a subprime mortgage, you must consider whether you’re willing to take on the risks associated with such a loan. Among the significant risks are:

  • Higher Interest costs: You’ll spend a lot more in mortgage interest than you would with a typical loan.
  • Difficulty finding a lender: Even some of the best mortgage lenders don’t accept subprime borrowers. You may be restricting your financing possibilities.
  • Increased monthly payments: If you choose an ARM, you risk higher interest rates and higher payments.
  • Risk of Foreclosure: If you don’t pay your subprime mortgage, your lender may foreclose your home which may harm your credit score.

Lenders must analyze borrowers’ “ability-to-repay” under Dodd-Frank financial reform rules. This guarantees borrower can repay their debts. More importantly, buying a house with weak credit might present you with several mortgage financing difficulties. 

What Is the Difference Between Prime and Subprime Mortgages?

If you’ve seen or read recent adverts about low mortgage rates, those are for prime mortgages. Borrowers who pose less risk to lenders are eligible for prime mortgages. When lenders advertise rates “as low as” a specific percentage, those rates are often reserved for borrowers with high to excellent credit scores ranging from 620 to 720 – individuals who are eligible for a conventional loan.

The down payment requirements for a prime mortgage (a conventional loan) might also be reasonably low – as little as 3% or 5% of the home’s purchase price.

On the other hand, subprime mortgage interest rates are substantially higher, reaching as high as 8% or 10%. Lenders frequently need a bigger down payment, such as 25 percent to 35 percent, to avoid lending a large quantity of money to a riskier borrower.

>> More: How to Choose the Best Mortgage

Are Subprime Mortgages Illegal? 

While pre-Great Recession subprime mortgages were terrible news for many consumers, the loans were not illegal. In fact, the major problem was the consumers who failed to understand the true nature of subprime mortgages but were enticed by the low payment benefits. They aren’t always bad, and they aren’t always illegal. 

In some circumstances, they are the only choice for borrowers facing financial hardship, like bankruptcy. Before taking out a subprime mortgage, it is essential that you discuss your financial situation with a financial and mortgage advisor. 

Who Offers Subprime Mortgages? 

Subprime mortgages are rare at major banks and credit unions. You’ll find this offer from a portfolio lender or a lender who advertises bad-credit or no-doc mortgages (non-QM). You might also consider loan programs designed to cater to borrowers who have “had recent credit events,” such as bankruptcy or foreclosure.

Should You Get a Subprime Mortgage? 

A subprime mortgage is, well, subprime. That doesn’t mean you can’t receive one for good reasons, such as to buy a great property at a bargain. If you’re working on restoring your credit and can make the payments, a subprime loan may be perfect for you. 

And if you feel it is a great idea and you plan on staying in the home for a long time, then consider refinancing your subprime mortgage five or ten years into the loan term. Your income and credit profile may have changed by then, making a conventional mortgage more reasonable. Scrutinize the numbers (including fees and new mortgage rates) to ensure refinancing saves you money, although swapping a subprime loan for a conventional loan is likely to pay off.

More importantly, if you have bad credit, taking out a subprime or non-prime mortgage is one of your many options. You may also be eligible for a government-backed mortgage, such as an FHA or VA loan. These loans require less credit and less money down. Consider all your options before taking on a subprime mortgage.

Alternatives to Subprime Mortgages

You may be wondering whether there are other options available to you. The good news is that negative credit customers have multiple mortgage financing options. Among the finest possibilities are government home loans:

USDA Loans

USDA loans allow you to buy qualifying rural residences. Borrowers with credit scores below 640 must undergo more rigorous underwriting. But you may still qualify.

VA Loans

A VA mortgage loan is available to qualifying service members and veterans, regardless of whether or not they have a good credit score. Although the VA does not need a minimum credit score, some lenders do.

FHA Loans

FHA lenders frequently work with bad credit borrowers. Low credit scores (500) can qualify for FHA loans with 10% down. Borrowers with 580 or higher credit scores can get accepted with a 3.5 percent down.

Conventional Loans

Conventional loans are mortgages not backed by the government or a private institution. Mortgage lenders such as banks, credit unions, and other financial organizations make conventional loans and are responsible for the origination and servicing of the loans. 

Considering that the federal government does not insure conventional loans, they are the riskiest lenders to make. Therefore, traditional mortgages are offered to applicants with the strongest financial profiles. The down payment requirements for conventional mortgages range from 3 percent to 40 percent, depending on the mortgage product.

Are Subprime Mortgages Bad? 

Subprime mortgages are notoriously expensive due to the high-interest rates charged by lenders to individuals with poor credit histories. In addition, some subprime mortgages are structured as interest-only loans or as loans with an adjustable rate. This can result in major financial difficulties if the payments become unaffordable when interest rates rise, or principal payments are due.

Subprime mortgages are not available from all lenders. In addition, some of those that do so are dishonest and do not adhere to the guidelines, which require them to determine if payments are feasible. This can put you, your property, and your credit at risk.

While there are some positive sides to getting a subprime mortgage, the risks seem to outweigh the benefits by a mile. However, if you are sure of bent on taking a subprime mortgage, you should consider discussing it with a financial advisor. 

Bottom Line: What Is a Subprime Mortgage? 

In an emergency, a subprime loan may be the best alternative. But keep in mind that the larger the subprime loan, the greater the interest costs. For example, a 30-year subprime mortgage loan could cost you tens of thousands more than a 30-year prime loan. Consider whether you need a loan now or should wait till you’ve improved your credit score and your chances of getting a prime loan.

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Elijah Bishop
Elijah Bishop

Elijah A. Bishop is a Senior Personal Finance Writer who has been writing about real estate and mortgages for years. He has a degree in English, Media and Creative writing from the University of Georgia. He also holds a realtor license and has been in and out of the US mortgage industry as a loan officer. Bringing over 15 years of experience, Elijah produces content that analyzes ethnicities, race, and financial well-being. His areas of expertise are mortgages, real estate, and personal loans.