Over the last decade, there's been no shortage of news coverage of subprime mortgages, as commentators and analysts have discussed and debated the risks and rewards they pose to borrowers and to lenders who issue them. For all the ink (and pixels) dedicated to the topic, there still isn't universal agreement on what "subprime mortgage" means. Here's our best shot at a definition:
Subprime mortgages are home loans designed for and marketed to borrowers with lower credit scores and/or poor credit histories. Experian characterizes sub-prime borrowers as those with FICO® scores between 580 and 669, but lenders in different parts of the country define subprime using different credit score "cut-offs," along with other measures of creditworthiness.
One thing lenders do agree on is that candidates for subprime mortgages are likelier miss payments or default on their loans than borrowers with better credit. And because subprime borrowers are seen as greater repayment risks, lenders typically charge them higher interest rates and fees.
The forms those higher prices take can vary by loan type, but all subprime mortgages have a couple of attributes in common:
- High closing costs. Lenders offset the risk of lending to borrowers with poor credit is by collecting high up-front payments. Origination fees of 10% or more were not uncommon before the financial crisis, but regulations have dialed them back to can range.
- High interest rates. Rates on subprime mortgages are typically several points higher than those on conventional mortgages — a difference that can cost you tens of thousands of dollars over the lifetime of the loan.
Types of Subprime Mortgages
Here are three types of nonconventional subprime mortgages you may encounter if your credit is less than optimal:
Adjustable Rate Mortgages (ARMs)
By far the most common subprime home loan is the adjustable-rate mortgage (ARM), which starts with an affordable rate, then shifts to a "floating" rate tied to a published central-banking interest rate such as the one-year London Inter-Bank Offer Rate (LIBOR). This shift can increase monthly payments significantly, straining household budgets and adding significant unpredictability to home finances. These factors certainly contribute to the relatively high default rates typical of subprime mortgages.
These loans have repayment periods of 40 years (480 months) or even 50 years (600 months) instead of the 30 years (360 months) associated with conventional mortgages.
At comparable interest rates, a loan duration 33% to 67% longer than a conventional mortgage's could cost you tens or even hundreds of thousands of dollars over the lifetime of the loan. And of course interest rates on subprime mortgages are not comparable to those of conventional mortgages — they're typically higher, so the long repayment period has an even greater sting.
With an interest-only mortgage, the borrower has the option, during the initial part of the repayment period (typically 5 to 7 years), to pay only the interest due on the loan (without paying back principal). At the end of this intro period, the borrower can renew the loan or refinance and begin paying down principal.
The APRs are typically a half-point or more higher on interest-only mortgages than on comparable loans; and interest-only loans also often come with origination fees that are even steeper than on other subprime loans.
This type of mortgage tends to work best for borrowers who use interest-only payments option as an emergency option. These borrowers routinely make full principal-and-interest payments, and make reduced interest-only payments on months with unexpected expenses. Borrowers who exercise the interest-only payment option face greater risk of loss than conventional mortgage holders if they're forced to sell the home in a period of flat or falling property values.
For Best Results with Subprime Mortgages
The urge to buy a house is a powerful one, and the desire to seal the deal—any deal—that puts those keys in your hand can be hard to resist. If a subprime loan is your only avenue to that goal, be aware that high up-front costs, steep interest rates, and the unpredictable nature of ARMs make subprime mortgages perilous for many borrowers. Consider looking for alternatives before you sign on that line:
- Shop around with multiple lenders; each defines subprime differently, and you may qualify for a prime loan with one lender even if others offer only subprime loans.
- Ask lenders if you qualify for an FHA Mortgage and pursue that instead of a subprime loan. If you're a veteran, investigate VA loans.
- Consider renting for another year and working toward building up your credit score. Consider using nonprofit credit counseling services to help in this effort.
If you've weighed all the pros and cons, and still want to pursue a subprime loan, consider making refinancing a goal. A popular strategy for subprime mortgages is to refinance long before the life of the subprime loan is up (and ideally before adjustable rates ratchet up and increase monthly payments). This involves taking out a new conventional mortgage, with better borrowing terms, and using it to pay off the subprime loan in full.
That approach can be fruitful, but it's wise to begin planning for it as soon as you take out the subprime loan. Here are some guidelines to bear in mind.
- You'll need a better credit score to qualify for better loan terms in five or ten years, and paying off your subprime loan can help as long as you keep up with your payments and make them on time every month.
- Keep in mind that you'll have a down payment and closing costs for the new mortgage, and take steps to make sure you'll have them when the time comes. If your income and property value climb steadily, those things may take care of themselves, but neither of those things is guaranteed.
- Make sure to maintain your property to help it retain its value. Even if you plan to remain there after you refinance, act as if you'll be selling the home and have it in spruce condition when you apply for the new loan.
Subprime mortgages aren't for everyone, and in an ideal world, they're not for you. Try to navigate around them, and if you choose to get one, know the risks and steer carefully.