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Subprime mortgages are home loans designed for "risky" borrowers—those who lenders consider less likely than most to repay their debts. Like other subprime loans, subprime mortgages come with relatively high interest rates and fees.
Understanding Subprime Mortgages
Lenders may classify subprime borrowers as those with FICO® Scores☉ between 580 and 669. However, every mortgage lender has its own definition of subprime and its own policies for setting fees and interest rates on subprime loans.
This underscores the importance of shopping around for your mortgage. It's possible you'll qualify only for a subprime mortgage with one lender but another lender will consider you eligible for a conventional mortgage. Even if all lenders consider you a subprime borrower, some will likely offer better loan terms than others.
Pricing on subprime mortgages can vary by mortgage type (see below), but nearly all subprime mortgages share these attributes:
- High closing costs: Lenders offset some of the risk of lending to subprime borrowers by collecting high fees upfront. Origination fees may be more than 1 percentage point higher on subprime loans than on conventional loans.
- High interest: Rates on subprime mortgages are typically several percentage points higher than what's available with conventional mortgages.
Types of Subprime Mortgages
There are three types of subprime mortgages you may encounter:
Adjustable-Rate Mortgage (ARM)
ARMs start out with relatively low introductory interest rates that shift to a variable rate after a specified time period (typically one year). This variable rate is tied to a published central-banking interest rate such as the Monthly Treasury Average Index.
When an ARM's interest rate changes, which may happen annually, it can significantly increase the amount of your monthly mortgage payment. Even with careful planning, a rate hike can strain household budgets.
With a repayment period of 40 or even 50 years compared with the 30-year norm of conventional mortgages, extended-term mortgages can mean making hundreds of additional payments over the life of the loan.
When those payments are based on a higher interest rate common to subprime mortgages, an extended-term mortgage could easily cost hundreds of thousands of additional dollars over a conventional loan for a prime borrower.
With an interest-only mortgage, you have the option during the first five to seven years of the loan to pay only interest due on the loan (no principal). At the end of this introductory period, you can renew the loan or refinance, but you must begin paying down principal.
Interest-only mortgages work best if you make standard interest-plus-principal monthly payments and only resort to lower interest-only payments in cases of emergency, such as times with unexpected expenses. Making a habit of interest-only payments puts you at risk of having to sell the house at the end of the introductory period. In markets where prices are declining, that could even mean ending up "underwater" on the loan and facing foreclosure or a short sale.
Risks of Subprime Mortgages
- High interest rates: The main downside to a subprime mortgage is its high cost in interest. The higher interest rates and fees that accompany a subprime mortgage can significantly increase the amount you'll pay for your home over the life of the loan.
- High down payment requirements: Conventional mortgages typically require 20% down payments. Government-backed mortgages and some other non-subprime mortgages allow lower down payments, but some subprime lenders require down payments of 25% or more.
- Paying more, for longer: By adding additional payments and stretching out the duration of the loan, extended-term mortgages can amplify the effects of those high interest rates.
- Uncertainty: Adjustable-rate mortgages make it difficult to predict monthly expenses from one year to the next, and annual hikes are likely to be as high as the law allows in a climate of rapidly rising interest rates.
Should You Get a Subprime Mortgage?
As the name implies, a subprime mortgage is less than ideal. Here are some scenarios in which you might consider getting one, and when you'd be better off thinking twice about it.
When a Subprime Mortgage Might Be a Good Choice:
- You've found a home that's a rare bargain you don't want to let slip away.
- You're on the path to rebuilding your credit and you're confident you can afford the payments, today and in the future.
- You plan to stay in the house for a decade or so and anticipate refinancing. (This can be tricky in times of rising interest rates; while improving your credit could lift you out of subprime status in five or 10 years, the lowest available rates by then could be comparable to those of today's subprime loans. On the other hand, rates could peak and begin falling again within that time frame.)
- You plan to refinance with a larger down payment on the strength of a reliably anticipated increase in income or ready cash (for instance, if you expect an inheritance or plan to sell a real estate or other assets).
When a Subprime Mortgage Might Not Be a Good Choice:
- You can barely cover the payments based on current income.
- You only qualify for an ARM and have to stretch to make the introductory payments. (This is the same issue as the preceding item but ratcheting ARM rates will compound the difficulty.)
- You have the option of getting a cosigner with good credit who can help you qualify for better-than-subprime loan terms.
- Your credit scores put you on the cusp of qualifying for a non-subprime loan, and you can take steps in the next six to 12 months to improve your mortgage readiness.
The Bottom Line
If your credit history is short or spotty, a subprime mortgage could be your best opportunity to get into the house of your dreams. But they come at a steep price, so before accepting one:
- Shop around for the best possible terms.
- Run the numbers carefully to make sure you understand the true cost of the loan.
- Make sure you are confident you can make the payments.
- Understand your options for potentially refinancing for better terms at some point in the future.
Instead of getting a subprime mortgage, you might choose to take the opportunity to understand what's holding back your credit report and credit score. Given enough time, you could improve your credit to the point where you don't have to consider a subprime mortgage.