What is a Subprime Mortgage?

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Definition:

A subprime mortgage is a type of mortgage with a high interest rate that lenders usually offer to borrowers with poor credit.

🤔 Understanding a subprime mortgage

A subprime mortgage is a mortgage that charges an interest rate higher than the rate charged to borrowers with better credit scores. The prime rate is a baseline interest rate that banks use when pricing their other loans, especially short-term variable rate loans. It also has a little influence over the rates for fixed-rate loans, though the influence drops as terms increase. It typically adjusts with changes in the federal funds rate (a benchmark interest rate). Borrowers with good credit can typically get mortgages at or below the prime rate. People with poor credit who apply for a mortgage usually have to borrow at higher interest rates, assuming the lender is willing to offer a loan at all, making their loans subprime mortgages.

Example

Many subprime mortgages are adjustable rate mortgages (ARMs). Mortgages with adjustable rates are like typical mortgages, except for the fact that the interest rate on an ARM changes with changes in the interest rate market. If rates increase, the ARM’s rate increases. Many subprime borrowers choose ARMs because they often come with lower initial interest rates. However, after the initial interest rate period, the rates can increase, leading to higher monthly payments.

Takeaway

A subprime mortgage is like an old, broken down car…

Cars are one of the most common ways for people to get around. Ideally, you have a new, well-tuned vehicle that gets good mileage and is reliable. This is like a conventional mortgage. If you’re less lucky, you might have an old, beat up car that’s less reliable or gets bad gas mileage. These are like subprime mortgages. They can help you buy a home (get from point A to point B), but they aren’t the best option and are often more expensive (like paying for more gas with a car that gets bad mileage).

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What is a subprime mortgage?

A subprime mortgage is a type of mortgage that charges an interest rate higher than the prime rate. The prime rate is a benchmark rate that banks use when pricing their variable-rate loans. Borrowers with strong credit profiles can borrow money at the prime rate or below, while those with poor credit have to get subprime loans.

Because subprime mortgages carry higher interest rates than typical loans, they are more expensive than traditional mortgages. Borrowers wind up paying more each month to borrow the same amount, meaning that they pay more over the life of the loan.

Some subprime mortgage lenders add additional requirements for borrowers, such as making them pay additional fees when getting the loan.

How does a subprime mortgage work?

Subprime mortgages work very similarly to typical mortgages. The borrower applies for a loan from a lender. The lender assesses the application and decides whether or not to offer a loan. Based on the applicant’s credit history and other factors, such as the down payment, the lender may decide to offer a subprime mortgage instead of a conventional one.

Generally, lenders offer subprime loans to borrowers with credit scores below 620 (on a scale of 300–850). This is below the average credit score of American consumers.

Often, subprime mortgages come with different repayment terms than typical mortgages, such as adjustable interest rates or interest-only payments.

What are the types of subprime mortgages?

There are many different types of subprime mortgages.

Interest-only

Initially, an interest-only mortgage payment only represents the interest that accrues each month. This means that the bill the borrower receives will be much lower than it would have been if the bill included principal payments (the non-interest portion of the loan). However, it also means that the borrower will make no progress toward paying off their debt during that time.

After a set period, often five or 10 years, the lender will start billing for interest plus principal. This means that the monthly payment will increase, usually significantly. If the borrower isn’t prepared, it can leave them struggling to pay the newly increased bill.

Adjustable rate

An adjustable rate mortgage (also called an ARM) has an interest rate that can change over time.

Typically, ARMs have an initial period with a fixed rate. After that period, the interest rate can change on a regular schedule. For example, a 5/1 ARM has an initial interest rate that lasts for five years. Once the five years pass, the rate changes once per year.

Typically, after the initial period, the interest rate of the loan increases. This means that the monthly bill will also increase. If market interest rates increase, the loan’s interest rate, and monthly payment, could continue increasing each year.

ARMs typically start cheaper than fixed-rate mortgages, but they don’t provide the same certainty in the monthly payment and could leave the borrower unable to make their payments if the rate rises too high.

Dignity mortgage

With a dignity mortgage, you pay a higher than typical interest rate on an otherwise normal mortgage. If you make every payment before the due date for a set period, typically five years, the lender will reduce the loan’s interest rate. The lender will also apply your excess interest payments to the loan’s principal. You’ll then continue to pay back the loan at the lower rate.

If you miss payments, it can delay the rate reduction or rule it out entirely, leaving you with a permanently more expensive loan.

What are subprime mortgage rates?

Adjustable mortgage interest rates change regularly based on benchmark rates like the federal funds rate and the prime rate. By definition, subprime mortgage rates are higher than the prime rate, which well-qualified borrowers receive.

In 2019, prime mortgage rates were roughly 4%, but subprime rates could reach as high as 10%, making them more than twice as expensive than a prime loan.

What is the difference between subprime and prime mortgages?

There are multiple differences between subprime and prime mortgages.

People with poor credit typically can only qualify for subprime mortgages because the higher rates compensate the banks for increased risk. Prime loans are only available to people who have good credit. They use the terms of subprime mortgages to compensate for the increased risk of lending to people with bad credit.

Another major difference is the cost of the loans. Prime loans have far lower interest rates than subprime mortgages. Two people who borrow the same amount will pay wildly different amounts if one gets a prime mortgage and the other gets a subprime one.

Many subprime mortgages have different terms and conditions than prime mortgages. For example, adjustable rates are more common for subprime mortgages and than prime loans. Interest-only payments are a feature you’ll rarely see outside of subprime loans.

Today, subprime mortgages typically require a hefty down payment from the borrower. Some subprime mortgages historically didn’t have any down payment requirement.

How did subprime mortgages contribute to the 2008 housing market crash?

Subprime mortgages played a major role in the 2008 housing market crash. People began borrowing money to buy homes in the early-to-mid 2000s, taking advantage of low interest rates to purchase expensive homes. Subprime lending expanded during this time, and many borrowers with poor credit received approvals from banks. Sometimes, banks would bundle these loans into mortgage-backed securities, or subprime mortgage bonds.

As the demand for housing grew, it created a bubble in the real estate market. Housing prices grew at accelerating speeds.

Between 2004 and 2006, the Federal Reserve increased the federal funds rate, a benchmark interest rate that affects all other rates in the United States, more than a dozen times to help fight off inflation in the housing market, increasing it from 2.25% to 5.25%.

Rising rates led to a burst in the real estate bubble. Many subprime borrowers weren’t able to make mortgage payments and found themselves underwater on their loans. Banks began foreclosing on homes, but couldn’t sell them for enough to recoup their losses. This also meant that holders of mortgage-backed securities lost money. These losses forced many large banks to shed staff or close.

Are subprime mortgages still available?

Subprime mortgages became highly unpopular in the wake of the 2008 financial crisis. Many regulations prevented lenders from offering similar loans. However, subprime mortgages have made a resurgence in recent years. Today, there are some lenders that specialize in subprime mortgages. However, many of the requirements for getting a subprime mortgage have changed. Today, they often require higher down payments than prime loans and better debt-to-income ratios.

Are subprime mortgages bad?

Subprime mortgages are not necessarily a bad thing. For people with poor credit, they are one of the only options for borrowing money to purchase a home.

However, that doesn’t mean that they’re a good thing either. Subprime mortgages can be incredibly expensive for borrowers and risky for lenders. Borrowers considering taking out a subprime mortgage need to consider their budget and whether they can truly afford the loan payment through the whole life of the loan.

Similarly, lenders need to consider the risks of subprime lending and ensure they can withstand the potential losses.

Are subprime mortgages bad?

Subprime mortgages are not necessarily a bad thing. For people with poor credit, they are one of the only options for borrowing money to purchase a home.

However, that doesn’t mean that they’re a good thing either. Subprime mortgages can be incredibly expensive for borrowers and risky for lenders. Borrowers considering taking out a subprime mortgage need to consider their budget and whether they can truly afford the loan payment through the whole life of the loan.

Similarly, lenders need to consider the risks of subprime lending and ensure they can withstand the potential losses.

Who should consider a subprime mortgage?

Lenders designed subprime mortgages for people with poor credit. That means that you should only consider a subprime mortgage if you have poor credit. People with good or excellent credit should be looking for prime mortgages.

If you do have poor credit, a subprime mortgage may be worth considering if you want to buy a home. Before applying, make sure that you can afford the payments and won’t be at risk of default if something happens, such as an adjustable rate increasing.

Another path you can take is waiting and working to improve your credit. Taking the time to build credit can help you qualify for a prime mortgage, which can save you a lot of money in the long run.

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Sign up for Robinhood and get your first stock on us.Certain limitations apply

The free stock offer is available to new users only, subject to the terms and conditions at rbnhd.co/freestock. Free stock chosen randomly from the program’s inventory. Securities trading is offered through Robinhood Financial LLC.

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