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A subprime mortgage is a home loan targeted at borrowers whose credit histories and credit scores indicate moderately high risk of failure to repay their loans. Like other types of subprime loans, subprime mortgages come with relatively high interest rates and fees. Borrowers who accept subprime mortgages typically do so because they can't qualify for a "conventional" mortgage that offers better borrowing terms.
Reasons you might only qualify for a subprime mortgage include having a relatively short credit history (if you're new to the credit market) or a credit history that includes serious negative events, such as a home foreclosure, bankruptcy or recent missed payments.
How Do Subprime Mortgages Work?
Subprime mortgages are home loans with pricing (i.e., interest rates and fees) tailored to relatively high-risk borrowers, also known as subprime borrowers. Experian defines subprime borrowers as those with a FICO® Score* of 580 to 669, but lenders define subprime according to their own criteria. Lenders in different housing markets around the country set minimum credit score requirements as they see fit and may define subprime using other creditworthiness criteria as well.
This underscores the importance of shopping around for mortgages and any other type of consumer credit. Because different lenders use different lending criteria, it's possible, depending on your credit scores, that you'll be slotted for a subprime mortgage by one lender but qualify for a conventional mortgage with another.
The pricing on subprime mortgages can vary by mortgage type (see below), but all subprime mortgages have some attributes in common:
- High closing costs. Lenders offset the risk of lending to borrowers with subpar credit by collecting high processing fees upfront. Origination fees on conventional mortgages typically fall between 0.5% and 1% of the total loan amount, but may be a percentage point higher on subprime loans.
- High interest. Rates on subprime mortgages are typically several percentage points higher than those on conventional mortgages—a difference that can cost you tens of thousands of dollars over the lifetime of the loan.
When you apply for a mortgage, you do not need to specify whether you are seeking a subprime or prime loan. You simply submit an application and, based on your credit reports, credit scores and other financial information, the lender will offer you a loan with the terms it thinks you deserve. If you are deemed a subprime borrower, the lending terms will reflect that in higher interest rates and fees. (If you are seen as a less risky applicant, you'll likely receive better rates and fees, and if your credit is poorer than what your lender considers subprime, your application may be declined altogether.)
Aside from pricing, subprime mortgages work much the same as conventional mortgages available to borrowers with better credit: The mortgage issuer reviews your credit, income and, possibly, your savings or other assets and decides how much it is willing to lend you. The lender offers you a loan at a specified interest rate with specific fees, to be paid in monthly installments for a set repayment period, such as 30 years. If you fail to make your loan payments, the lender has the right to foreclose—take back the house—and sell it in an attempt to recoup your lost payments.
Types of Subprime Mortgages
Here are three types of subprime mortgages you may encounter:
Adjustable-rate mortgages (ARMs): ARMs start out at relatively affordable "teaser" rates then, after a specified introductory period (typically one year), shift to a floating rate tied to a published central-banking interest rate such as the Monthly Treasury Average Index (MTA Index or 12-MAT). This shift, which may occur annually, can strain household budgets and add significant unpredictability to home finances.
Extended-term mortgages: These loans have repayment periods of 40 years or even 50 years instead of the 30 years typical of conventional mortgages. At comparable interest rates, a loan duration 33% to 67% longer than that of a conventional mortgage could cost you tens or even hundreds of thousands of dollars over the life 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.
Interest-only mortgages: With an interest-only mortgage, the borrower has the option, during the initial part of the repayment period—typically five to seven 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 higher by half a percentage point or more on interest-only mortgages compared with comparable conventional loans; and origination fees on interest-only loans are often even higher than on other subprime loans.
Interest-only mortgages tend to work best for borrowers who use interest-only payments 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 their home in a period of flat or falling property values.
What Are the Disadvantages of Subprime Mortgages?
The main downside to a subprime mortgage is its high cost. 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.
By adding additional payments and stretching out the duration of the loan, extended-term mortgages can amplify the effects of those high interest rates. And adjustable-rate mortgages, with their regular recalculation of your mortgage interest rate, can make it difficult to predict and plan your household spending from one year to the next.
Should You Get a Subprime Mortgage?
As the name implies, a subprime mortgage is less than ideal. That's not to say there aren't reasonable justifications to get one, such as to buy a home that's a rare bargain you don't want to let slip away. If you're on the path to rebuilding your credit and you're confident you can afford the payments, you may be right in taking out a subprime loan.
If you do, and you plan to stay in the house for more than a decade or so, consider refinancing your subprime mortgage five or 10 years in the future. By then, your income and credit profile may have changed in ways that make a more affordable conventional mortgage an option. Before doing so, review the numbers carefully (including the fees as well as the interest rates on a new mortgage) to make sure refinancing saves you money, but if you're able to swap a subprime loan for a conventional one, there's a good chance it will pay off.
Consider Improving Your Credit Score
If a subprime mortgage is all you qualify for today, and you're in a position to wait a year (or longer) before financing your first home, another option is to take steps today to improve your credit. That's also a good idea if you choose to pursue a subprime mortgage today with the goal of refinancing years from now. (Heck, it's a good idea if you plan to borrow money at any point in the future, for any reason.)
Adopting habits today that promote improvements in your credit reports and credit scores can bring many benefits. Qualifying for better terms on loans and credit cards could save you thousands of dollars, but there are other advantages to good credit as well, including reduced insurance premiums and lower security deposits on apartment leases and on car and equipment rentals.