Subprime mortgages are home loans for borrowers with lower credit scores, often below 600, who wouldn’t qualify for a conventional mortgage. They usually carry higher interest rates and down payment requirements than conventional mortgages. Commonly known for fueling the Great Recession, subprime mortgages now exist as nonprime mortgages under stricter rules, but they are still risky and generally not the best kind of loan to sign up for.
Subprime mortgage rules
Synonymous with the Great Recession, subprime mortgages took on a new name following the financial meltdown in 2008. Nonprime mortgages, as they’re known today, are regulated by the Consumer Financial Protection Bureau (CFPB), which laid out new rules under the Dodd-Frank Wall Street Reform and Consumer Protection Act.
Before a lender can issue a subprime or nonprime mortgage, borrowers must undergo homebuyer’s counseling through a representative approved by the U.S. Department of Housing and Urban Development (HUD). In addition, lenders must properly underwrite subprime mortgages according to the standards set under Dodd-Frank. Under CFPB rules, some subprime mortgages fall into a new non-qualified mortgage category. This designation limits legal protections for lenders, so they’re potentially risky for the lender, as well.
“Lenders aren’t making the same kinds of subprime loans that they did during the run-up to the Great Recession,” says Austin Kilgore, director of digital lending at Javelin Strategy & Research. “The biggest reason is regulatory issues.”
He notes that the “ability-to-repay” (ATR) provision in Dodd-Frank requires lenders to undergo a thorough process to determine whether potential borrowers are capable of paying back the loan under the established terms.
“If you violate the ATR rule as a lender, you can potentially be sued or be subject to regulatory enforcement,” Kilgore says. “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.”
The CFPB periodically reviews the rules and makes changes when deemed necessary. Dodd-Frank has also come under criticism by some. In 2018, Congress voted to roll back parts of the law. Although these changes didn’t erode or directly impact provisions to protect consumers from riskier subprime or nonprime mortgages, they did add another layer of uncertainty to an already risky loan.
Subprime mortgage risks
Because subprime mortgages are generally issued to borrowers with lower credit scores, these loans raise risks for the lender. To make up for that risk, the lender may charge higher interest rates and fees than you might see on a conventional loan. Current 30-year fixed mortgage rates hover around 3.56 percent, but subprime mortgages can have interest rates as high as 10 percent.
|Amount of Loan||Down Payment||Interest Rate||Loan Term||Monthly Mortgage Payment|
|$200,000||20% ($40,000)||3.56%||30 Years||$723|
|$200,000||20% ($40,000)||10%||30 Years||$1,404|
Moreover, subprime or nonprime mortgages generally require larger down payments than their conventional counterparts. In the above scenario, a 20 percent down payment equates to $40,000 — but down payment requirements on subprime mortgages can climb to as high as 35 percent. In this example, that equates to $70,000.
Plus, terms on subprime mortgages can stretch longer than usual. Most conventional mortgages are designed to be paid off in 15 or 30 years, but some fixed-rate subprime mortgages can run the course of 50 years. Keep in mind that the longer the term to pay off your mortgage, the more interest you’ll pay throughout the life of the loan. This could mean paying hundreds of thousands more than you would if you had taken out a conventional 15- or 30-year mortgage.
Generally, this outweighs the prospect of smaller monthly payments. Ask your lender for the amortization schedule, which breaks down your monthly payments, as well as how much you’d pay in total over the term of the mortgage. The numbers may surprise you.
Types of subprime mortgages
Subprime or nonprime mortgages function similarly to conventional mortgages. Here are some examples of the different types of subprime mortgages.
Fixed-rate subprime mortgage
Fixed-rate subprime mortgages work just like conventional fixed-rate mortgages. The borrower gets a set interest rate and the monthly payment remains the same each month. However, subprime fixed-rate mortgages may have longer terms. In the conventional space, fixed-rate mortgages tend to have terms of 15 or 30 years. Subprime mortgages can have 40- or even 50-year terms. While a longer term can mean smaller monthly payments, you’d pay more interest in the long run. On a 50-year mortgage, your total payment is dramatically higher, as opposed to a 30-year mortgage.
Subprime adjustable-rate mortgage (ARM)
You can also take out a subprime adjustable-rate mortgage, or ARM. A common one is the 3/27 ARM, in which the borrower gets a fixed interest rate for the first three years. Afterward, the rate readjusts for the remaining 27 years. Rate adjustments are based on the performance of a market index plus a margin. Each lender has a cap indicating by how much your rate can increase, so if you can’t make the peak monthly payment, you may be at risk of default.
With an interest-only loan, you pay only interest during the first few years, typically 10. This could mean smaller monthly payments at first, but you won’t pay off any principal, and you’d also build equity at a much slower rate. Home equity is the difference between your loan balance and the appraised value of your home. It represents how much of your home you actually own. You can borrow from your equity when you need cash, such as through a home equity loan or home equity line of credit (HELOC). With an interest-only loan, your equity is limited, and because you’re not shaving off any principal in the first few years, you may find yourself in a longer cycle of debt.
When you get a dignity mortgage, you make a down payment of at least 10 percent and take on a high interest rate. If you make timely payments for a certain period, typically five years, the amount paid toward interests gets used to lower your balance, and your interest rate is lowered to the prime rate, or the rate that most large banks charge their most creditworthy borrowers, which is largely determined by federal funds rate set by the Federal Reserve. This type of loan can benefit you only if you can afford to make larger payments during the beginning of your term.
Alternatives to a subprime mortgage
If you’re considering taking out a subprime or nonprime mortgage because of your credit history, know that it isn’t your only option. Many government-backed mortgages are designed to help those with less-than-favorable credit. They also tend to have lower interest rates than conventional mortgages.
- 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 lower than 580, there are several ways you can improve your credit score in order to qualify for a better rate.
- USDA loans: These loans are designed for low-income families who would like to live in a rural designated area. (Some qualifying locations are near large metro areas.)
- VA loans: If you’re a veteran or active member of the armed forces, look into VA loans. Issued by the Department of Veterans Affairs, these loans require no down payment.
Subprime or nonprime mortgages are aimed at borrowers who may not have adequate credit to qualify for a conventional mortgage — but, they can come with higher interest rates, fees and down payment requirements, so in the long run, you could be paying much more than you would have with a conventional mortgage.
Keep in mind that a subprime mortgage isn’t your only option. Many government-backed loans, such as FHA loans and USDA loans, are designed to help borrowers with lower credit scores. If you’re a first-time homebuyer, there are many first-time homebuyer assistance programs, as well. Before applying for a mortgage, consider improving your creditworthiness to qualify for a better rate.