A subprime mortgage loan is a loan made at rates above the prime lending rate, usually to borrowers with a poor credit rating who cannot qualify for lower loan rates. Because of their poor credit ratings, borrowers of subprime mortgages are usually considered at higher risk of not being able to pay back their loans, thus justifying the higher rates. Subprime loans have been blamed for the housing crash and have gotten a bad rep in the past few years.
Subprime mortgages are most commonly used by people with low credit ratings. All credit ratings range from 300 to 850. Your credit rating takes into account things such as late bill payments, owing large amounts on credit cards or having other large unsecured debts, previous bankruptcy, court judgements, repossessions, and liens against your property. According to the Federal Citizen Information Center, a score lower than 600 indicates high risk to lenders and “could lead lenders to charge you much higher rates or turn down your credit application.” Subprime lenders specialize in providing mortgage loans to such high-risk borrowers.
The main benefit of a subprime loan is that it is available to borrowers who do not qualify for prime rate loans, and may be the only option for those who have declared bankruptcy or have large debts. The prime lending rate, or prime interest rate, is based on the interest rate banks charge their most creditworthy customers. It is related to the rate at which banks lend money overnight to each other. Subprime financing also generally allows for higher debt ratios than traditional financing. Conventional mortgage lenders will usually only lend to people whose debt-to-income ratio is around 40 percent, while subprime lenders will often lend at ratios of up to 50 percent.
Conventional loans are usually offered as either 20- or 30-year fixed rate mortgages, or as adjustable rate mortgages, where the rate is fixed for the first few years and then set at the prime rate plus a margin. Subprime loans, in contrast, are almost always adjustable only, and have a much higher margin than prime rate adjustable loans. Mortgage fees are also higher for subprime loans, and there is often a large prepayment penalty. Subprime lenders set the rates for individual borrowers using risk-based pricing, in which the worse a borrower's credit rating, the higher their rates and fees will be. Some subprime loans also come with balloon payments – a single very large payment -- after a period of time.
2/28 and 3/27 ARMs
The 2/28 and 3/27 adjustable rate mortgages (ARMs) are a common type of subprime mortgage. In the 2/28 mortgage, the rate is fixed for two years and in the 3/27 it is fixed for three years. After this period, the rate is reset to the prime rate (or a similar rate) plus a margin, for the rest of the loan period. While the initial rate may be lower than the prime lending rate, the margins on these loans tend to be much higher than on prime rate adjustable loans and the result is that the loan rate may jump considerably after the initial two- or three-year period. These types of loans may be useful for people planning to sell their property after the initial period, or for people who are able to build up their credit rating and refinance after the initial period.
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