Homeownership is a fundamental part of the American Dream. Chances are, you’ll need to take out a loan if you want to enter the housing market, and if you’re a borrower who gets a loan with payments you really can’t afford, then you might lose your dream house. It’s irresponsible for lenders to give money to borrowers who can’t afford to pay it back, and many financial experts agree that practice by some financial institutions is what led to the subprime mortgage crisis and housing market crash.
Subprime Mortgage Definition
So, what is a subprime mortgage? It’s a loan for a borrower who doesn’t have great credit. The word “subprime” refers to “the credit characteristics of individual borrowers,” according to the FDIC. Lenders reserve prime rates for borrowers with the best credit reports and offer subprime — higher — rates to borrowers with credit issues. Typical credit characteristics of a subprime mortgage borrower include:
- Two or more 30-day delinquencies within the previous 12 months or one 60-day delinquency in the last 24 months
- A judgment, foreclosure, repossession or charge-off in the previous 24 months
- A bankruptcy within the last five years
- A FICO credit score of 660 or lower
- A debt-to-income ratio of 50 percent or higher, which means the borrower is not likely to meet his monthly payments
Subprime Mortgage Rates
Lenders charge higher rates on subprime loans because of the increased risk of lending money to borrowers with lower credit scores, who are more likely to default on mortgages than prime borrowers. These types of loans also might include prepayment penalties or balloon payments.
A prime mortgage generally has a fixed or adjustable interest rate, but a subprime loan is almost always an adjustable-rate mortgage. This means that interest rates on subprime mortgages can go up a lot over time and cost you more than you expect in interest, according to the Consumer Financial Protection Bureau.
If you’re looking for a mortgage and you have bad credit, start with an online search for different types of mortgage lenders in your state. You’ll likely get results that include subprime lenders. If your credit score is 580 or higher, you might qualify for a government-backed FHA loan, so look into that option, too.
The Subprime Mortgage Crisis
Subprime mortgages played a starring role in the 2008 financial crisis that impacted stock markets and economies around the world. First, too many subprime lenders gave mortgages to people who couldn’t afford them. Next, banks packaged these mortgages into investments called mortgage-backed securities and offered them as safe investment vehicles for individuals, hedge fund managers, and pension plans.
Because the subprime borrowers couldn’t make their payments, those investments weren’t safe at all. As homeowners defaulted on their loans, mortgage-backed securities’ values plummeted, resulting in major losses for investors. As the effect of these losses trickled down through the economy, more homeowners lost their jobs and couldn’t make their payments, which led to nearly 8 million home foreclosures, according to CNBC.
Subprime Lending in Today’s Market
Since the financial crisis of 2008, the federal government introduced stricter rules designed to ensure subprime lenders don’t make irresponsible decisions that could lead to another financial meltdown.
Now lenders are so strict that many first-time buyers and low- to middle-income earners can’t get a mortgage. Tougher policies have led to the development of products like Wells Fargo’s “3 percent down” mortgage, which requires borrowers to have a credit score of 620. Payments will still cost less than an FHA-insured loan, and if the borrower completes a homebuyer education course, he might earn an interest rate reduction, according to the bank.
Subprime Mortgage Legalities
The Dodd-Frank Act outlines the stricter lending requirements for subprime mortgage lenders. Some of the changes include:
- Borrowers must show documentation regarding employment income and debt levels.
- Lenders must confirm that borrowers can repay the mortgage.
- Lenders must clearly disclose all costs associated with the mortgage.
To get a subprime mortgage in today’s market you’ll need a higher credit rating than ever before — and you’ll have to provide more documentation to prove you can make your payments.
Identifying Subprime Mortgages
Subprime mortgages might be difficult to spot, but here are a few red flags to watch for:
- The lender might call the loan by another name, such as a “non-prime” mortgage.
- The loan has a high interest rate.
- The loan has a low rate but comes with high fees and penalties.
- You get solicited for a mortgage via phone or email.
Keep in mind that if you do accept a subprime mortgage, you must be able to make the payments. If you can’t, you might default on the loan and lose your home.
Subprime Mortgage Alternatives
You have options other than subprime mortgages if you want to buy a home. If you’re willing to delay your plans, try to boost your credit score and reduce your other debt to improve your debt-to-income ratio before applying for a mortgage. You might also try saving for a bigger down payment to qualify for a better mortgage in the future.
Another option is to consider other lenders. Even if one lender offers you a subprime mortgage, you might qualify for a better mortgage from a different company or financial institution.
These days, subprime mortgages are still available, but they’re harder to find. Before you take on a mortgage that could end up costing you way too much, do your research. Try to get an FHA loan or work on becoming a more attractive borrower so lenders don’t see you as a subprime lending risk.