When you apply for a mortgage, the lender looks through your credit and finances to determine your level of risk as a borrower. Depending on what that review reveals, you might qualify for a subprime mortgage instead of a conventional loan.
What is a subprime mortgage?
Subprime mortgages — also known as non-prime mortgages — are for borrowers with lower credit scores, typically below 600, that prevent them from being approved for conventional loans. Conventional loans are widely available and tend to have more favorable terms, such as better interest rates.
Subprime mortgages were one of the main drivers of the financial crisis that fueled the Great Recession. In the years leading up to the economic meltdown, lenders approved many subprime mortgages that borrowers were unable to pay back. In fact, approximately 30 percent of all mortgages originated in 2006 were subprime, according to a Credit Union National Association analysis of Home Mortgage Disclosure Act data.
While subprime mortgages still exist today — and might be referred to as a non-qualified mortgage — they are subject to more oversight. They also tend to have higher interest rates and larger down payment requirements than conventional loans.
How do subprime mortgages work?
Subprime mortgages are now regulated by the Consumer Financial Protection Bureau (CFPB), the agency created as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act, which was enacted in response to the subprime crisis.
One of the key rules the CFPB put in place is a requirement that any borrower who obtains a subprime mortgage must undergo homebuyer counseling through a representative approved by the U.S. Department of Housing and Urban Development (HUD).
Additionally, lenders must underwrite subprime mortgages according to Dodd-Frank standards, including the “ability-to-repay” (ATR) provision that requires a lender to thoroughly assess whether a borrower is capable of paying back the loan.
“If you violate the ATR rule as a lender, you can potentially be sued or be subject to regulatory enforcement,” says Austin Kilgore, director of Digital Lending at Javelin Strategy & Research. “So lenders that operate in the non-qualified mortgage space have a strong incentive to make sure they are adequately evaluating borrowers much more than the subprime lenders of 15 to 20 years ago did.”
That “non-qualified mortgage” designation limits legal protections for lenders, as well, which has kept many from operating in the space.
“Lenders aren’t making the same kinds of subprime loans that they did during the run-up to the Great Recession,” Kilgore says. “The biggest reason is regulatory issues.”
Are subprime mortgages bad or illegal?
While the subprime mortgages offered prior to the Great Recession were bad news — many borrowers were confused by attractive-sounding low payments that hid the realities of these loans — they were not illegal.
Today, with additional regulations, they aren’t always bad, and aren’t illegal. In some cases, they might be the only option for borrowers who have gone through challenging financial times, such as declaring bankruptcy.
Subprime vs. prime mortgages
If you’ve seen headlines recently about low mortgage rates, those apply to prime mortgages. Prime mortgages are available to highly-qualified borrowers who are less of a risk to lenders. When lenders advertise rates “as low as” a certain percentage, those rates are typically reserved for borrowers with good to excellent credit scores, from 620 on up — borrowers who qualify for a conventional loan.
With a prime mortgage (a conventional loan), the down payment requirements can be relatively small, too — as low as 3 percent or 5 percent of the home’s price.
The interest rates on subprime mortgages, on the other hand, are much higher — as high as 8 percent or 10 percent. Lenders often ask for a higher down payment, too, such as 25 percent to 35 percent, to avoid loaning a large sum of money to a riskier borrower.
Types of subprime mortgages
Subprime fixed-rate mortgage
A subprime fixed-rate mortgage works just like a conventional fixed-rate mortgage in that the borrower gets a set interest rate and the monthly payment remains the same for the length of the loan repayment period. The difference is that subprime fixed-rate mortgages sometimes have longer terms, such as 40 years, compared to the typical 15 or 30 years for a conventional fixed-rate loan.
Subprime adjustable-rate mortgage (ARM)
There are also subprime adjustable-rate mortgages, or ARMs, such as the 3/27 ARM, in which the borrower gets a fixed interest rate for the first three years, then the rate readjusts once a year for the remaining 27 years. The adjustments are based on the performance of a market index plus a margin. Most lenders have a cap on how much your rate can increase, but if you can’t make the peak monthly payment, you could be at risk of default.
With an interest-only loan, the borrower pays only interest during the first few years, typically seven or 10. This could mean smaller monthly payments at first, but no initial payoff of the loan principal, and delayed equity.
With a dignity mortgage, the borrower makes a down payment of at least 10 percent and takes on a high interest rate. If the borrower makes timely payments for a certain period — typically five years — the amount paid toward interest gets used to lower the loan balance, and the interest rate is lowered to the prime rate, or the rate that most large banks charge the most creditworthy borrowers. (This rate is largely determined by the federal funds rate set by the Federal Reserve.) This type of mortgage could be beneficial if you can afford to make larger payments during the beginning of your term.
Subprime mortgage risks
Because subprime mortgages are for borrowers with low credit scores, these loans raise risk for the lender. To make up for that risk, the lender charges higher interest rates and fees than you might see on a conventional loan. With a higher rate, you’ll pay significantly more overall for a subprime mortgage:
|*Median national price, Aug. 2021, National Association of Realtors
**Average 30-year fixed APR, Oct. 20, 2021, Bankrate
Source: Bankrate mortgage calculator
|Home price*||Down payment||Interest rate||Loan term||Monthly payment||Interest total|
|$356,700||$71,340 (20%)||3.35%**||30 years||$1,257||$167,544|
|$356,700||$89,175 (25%)||8%||30 years||$1,963||$439,160|
This example assumes both loans have a fixed rate and a 30-year term, but with a subprime mortgage, the rate structure and term don’t always work that way. Some can run the course of 40 years or longer. The longer the time to pay back the loan, the more interest you’ll pay.
Who offers subprime mortgages?
You won’t typically find subprime mortgages at the biggest banks and credit unions. This offering is more likely to be available through a portfolio lender or a lender that advertises bad-credit mortgages, no-doc mortgages or non-qualified mortgages (non-QM). You might also see language that indicates a loan program is geared toward borrowers who have “had recent credit events,” such as bankruptcy or foreclosure.
How do I know if I have a subprime mortgage?
Around 33 percent of all borrowers (not just of mortgages) fall into the subprime category based on credit score, according to Experian.
You might have a subprime loan if your mortgage has a much higher interest rate or a term longer than 30 years — or you had a down payment requirement higher than 20 percent (and you weren’t getting a jumbo loan or buying an investment property). Think back to the time when you applied for your mortgage, too. If you had a history of late payments, a loan default, an excessively high debt-to-income ratio or a credit score below 620, you could now have a subprime loan. You can also try asking your loan servicer for clarification.
If you do have a subprime mortgage, compare your credit then (when you applied) to now. If your personal finances have improved to put you in the running for a prime mortgage, consider refinancing to lower your rate and get better loan terms.
Should you get a subprime mortgage?
A subprime mortgage isn’t ideal due to steeper rates and other factors.
If your credit needs work, a subprime mortgage isn’t your only option. FHA loans and VA loans can be alternatives for borrowers with credit challenges — FHA loans, for instance, accept scores as low as 500 if you can make a down payment of at least 10 percent. If you’re a first-time homebuyer, there are many first-time homebuyer assistance programs, as well, some of which include credit improvement programs.
Alternatives to a subprime mortgage
- FHA loans – If your credit score is at least 580, consider an FHA loan with a down payment of 3.5 percent. If your credit score is between 500 and 579, you can qualify for an FHA loan with 10 percent down.
- VA loans – If you’re a veteran or active member of the armed forces, look into VA loans. Guaranteed by the U.S. Department of Veterans Affairs, these loans require no down payment and could have lower credit score requirements.
- USDA loans – USDA loans are designed for low- to moderate-income borrowers in rural designated areas. (Some qualifying locations are actually near large metro areas.) While some lenders might have a credit score minimum for USDA loans, others might have relatively lenient standards that can help you qualify.
Another alternative is to simply wait. Continue paying your bills on time, and focus on taking crucial steps to improve your credit. You might want to buy a house now, but you also don’t want to get stuck paying an overwhelmingly high interest rate.