When you are in the market for a mortgage, you may be told by a lender that you qualify for a subprime mortgage. What you will notice is that the loan will be offered at a higher rate than conventional loans. This raises a few questions; what is a subprime mortgage and how does it work? Read on to find out more on this.
A subprime Mortgage refers to a mortgage that lenders typically offer to borrowers with low credit ratings. People usually mistake ‘subprime’ as a reference to the interest rates that this kind of loan attracts; the term however refers to the credit rating or score of the borrower.
How Subprime Mortgage Works
To understand how subprime mortgages work; let’s look at the different requirements lenders impose on these loans.
Credit Scores for Subprime Mortgage
This class of mortgage is typically offered to borrowers whose credit score is below 640 points. That said lenders have varying ‘cut-off’ points for different classes of loans. It’s possible to get lenders who will offer subprime mortgages to customers with as low as 500 points. With such low points, one cannot qualify for a conventional or ‘prime’ mortgage.
Credit scores are used as a measure of a person’s creditworthiness. Fico scores are the most widely used credit scores and they are calculated from information found in a consumer’s credit report. The scores are given in a range of between 300 and 850 points.
Higher scores present a picture of a borrower who is good at credit management; a person who is capable and willing to pay off a loan, hence such borrowers present an acceptable level of risk. As such they are offered mortgages at lower interest rates and other less stringent terms.
On the other hand, borrowers with low credit scores are seen as bad credit managers. As such they present a high risk to the lender since they are deemed potential defaulters. To mitigate this risk, lenders can refuse to finance such people, and if they do tougher terms are imposed.
Down Payment on Subprime Mortgages
Before the financial crisis of 2007, borrowers could get loans with zero down payments. This held even for those with less than stellar credit histories. This however changed when the housing market crashed. Since then you can expect to pay at least a 5% down payment on a home even with an excellent credit score.
Since the housing crisis was largely blamed on subprime loans, paying a down payment on them became a necessity. While prime loans go for low down payments, subprime borrowers typically put a down payment that is 3 percentage points higher.
Subprime borrowers are also held to a much stricter verification process; this includes a thorough look at the source of the down payment, current, and future income prospects as well as other lines of credit.
Loan Terms on Subprime Mortgages
There are several classes of subprime mortgages. These are classified depending on the loan term and the interest rate structure. Here are the common ones;
Fixed-Interest Mortgages: This loan is offered on a 40 to a 50-year term. It comes with low monthly payments but at much higher interest rates.
Interest-Only Mortgages: For this loan, the borrower only pays interest; borrowers are not required to repay the principal amount at least during the initial term (first 7-10 years). After that, he can repay the principal or choose to refinance.
Adjustable-Rate Mortgages: With ARM loans, a borrower will begin with a fixed interest rate, and later the rate is adjusted. Typical ARM mortgages come at 2 to 3-year fixed rates, to begin with, and switch to variable rates for the remaining term.
Subprime mortgages are a good option for prospective homeowners with bad credit history. As such they could be the only reprieve for borrowers who have previously been declared bankrupt or whose debts outweigh their income. These loans come at higher interest rates than conventional ones and higher down payments. They also attract more scrutiny of a borrower’s finances before approval.