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If you dream of becoming a homeowner, but bad credit is getting in the way of making it a reality, a subprime mortgage might be a better option. While these loans are designed for higher-risk borrowers, they do come with some risks of their own.
Here’s what you should know before considering a subprime mortgage.
Who Are Subprime Mortgage Borrowers?
Mortgage applicants with poor credit scores and negative items on their credit reports are often considered subprime. Whereas, prime borrowers have good credit and a strong financial track record, so the lender is more likely to offer them a loan at a lower interest rate.
Today, financial institutions often use the term nonprime instead of subprime, but the meaning is the same. Generally, that’s defined as a borrower with a credit score of 660 or less. According to the Federal Deposit Insurance Corp (FDIC), a subprime borrower is also someone who:
- Had at least two payments that were late by 30 days in the last 12 months, or at least one payment that was late by 60 days in the last 24 months
- Experienced a judgment, foreclosure, repossession or charge-off in the past 24 months
- Filed for bankruptcy in the last five years
- Has a debt-to-income (DTI) ratio of at least 50%
Home loans designed for these types of higher-risk borrowers are considered subprime or nonprime mortgages.
The term subprime may sound familiar thanks to the subprime mortgage crisis. Prior to 2008, mortgage lenders had much looser standards for approving borrowers with poor credit scores and financial track records. These were also sometimes called no-doc loans because some lenders were not requiring documented proof of income.
Eventually, many of those borrowers defaulted on their loans. Between 2007 and 2010, foreclosures skyrocketed and banks lost tons of money, causing the government to bail out many big banks, while others merged or were sold through failure.
In response to the subprime mortgage crisis, the Dodd-Frank Act of 2010 was established to overhaul financial regulation in order to prevent a similar crisis in the future. Included in the act is a lender requirement called the ability-to-repay (ATR) rule. This rule requires mortgage lenders to establish a thorough process for evaluating whether a borrower is able to repay the loan according to its terms, pretty much ending the practice of no-doc mortgage loans.
Lenders also have to underwrite loans according to the standards outlined by Dodd-Frank. Violating these requirements could result in a lawsuit or other regulatory action. Additionally, subprime borrowers are required to attend homebuyer counseling provided by a representative approved by the U.S. Department of Housing and Urban Development (HUD).
Though there are much stricter rules surrounding subprime mortgages today, they are still considered more risky for borrowers and lenders over conventional mortgage loans.
Types of Subprime Mortgages
Like conventional mortgages, there are several types of subprime mortgages, including:
- Fixed-rate mortgages. With this type of loan, the interest rate is set for the duration of the mortgage and payments are the same amount every month. But unlike a conventional mortgage, which typically comes with a repayment term of 15 or 30 years, fixed-rate subprime mortgages can last 40 to 50 years.
- Adjustable-rate mortgages (ARM). Rather than one interest rate that remains fixed throughout the loan term, a subprime ARM offers a low introductory rate that eventually resets according to a market index it’s tied to. For example, with a 5/1 ARM, the borrower would pay the introductory rate for the first five years. After that, the rate would reset one or more times during the remaining 25 years. Usually, lenders cap how much the rate can increase.
- Interest-only mortgages. When making payments on an interest-only loan, the funds go toward only the accumulated interest for the first seven to 10 years. Then payments will go toward paying down principal and interest for the rest of the term.
- Dignity mortgages. This type of mortgage is like a hybrid of a subprime and conventional mortgage. Borrowers put down about 10% and agree to pay a higher interest rate for the first few years—typically five. If they make all their payments on time, the rate is lowered to the prime rate—the interest rate banks charge their most creditworthy customers.
Is a Subprime Mortgage Right for Me?
Taking out a subprime or nonprime mortgage is one option when you have poor credit. However, it’s not your only one; you may qualify for a government-backed mortgage such as an Federal Housing Administration (FHA) or U.S. Department of Veterans Affairs (VA) loan. These loans offer more relaxed credit score and down payment requirements. It’s important to consider all your options before pursuing a subprime mortgage.
Also know that nonprime home loans aren’t just for borrowers with bad credit. Some types of properties don’t qualify for conventional loans, such as certain condos or log homes. If you’re self-employed and don’t have much taxable income, you may also be a good candidate for a subprime mortgage. The same is true of foreign nationals in the U.S. who don’t have a credit history.
Benefits and Risks
One of the biggest benefits to subprime mortgages is that they provide an avenue for securing home financing when you don’t qualify otherwise.
However, just because you qualify for a subprime mortgage doesn’t mean you should borrow one. Though there are some benefits, there are also several risks to consider:
- Higher rates: Subprime mortgage borrowers generally have poor credit scores and other financial challenges. That means it’s much more risky for a lender to offer this type of loan than a traditional mortgage. To offset that risk, lenders charge higher interest rates. Right now, the average rate for a 30-year fixed rate conventional mortgage is under 3%, but the rate on a subprime mortgage can be as high as 8% to 10%, and require bigger down payments.
- Larger down payment: Another way some lenders offset the risk of subprime mortgages is by requiring higher down payments: as much as 25% to 35%, depending on the type of loan. That can be tough if home values are rising at a rapid rate and you risk getting priced out of your desired neighborhood. You also have to be careful not to put too much of your liquid savings into your home. In the case of a financial emergency, you need enough savings on hand to cover expenses, including your mortgage payment.
- Higher payments: Since you will likely have to pay a higher interest rate on a subprime mortgage, it means you’ll be saddled with a higher payment each month. Of course, you shouldn’t borrow more than you can afford to repay, and lenders will certainly check that. However, if your financial situation changes—like if you lose your job or experience a medical emergency—those high payments may become too much to handle. Missing mortgage payments can damage your credit considerably, or worse, trigger a foreclosure.
- Longer terms: With a conventional mortgage, the terms are typically for 15 to 30 years. Subprime mortgages, on the other hand, often stretch the repayment term to 40 or even 50 years. So you could spend a good chunk of your life with a mortgage payment. But this also means that the amount of interest you pay over the life of the loan increases dramatically.
What’s Needed to Get Approved
Though subprime mortgages are designed for borrowers with lower credit scores, lenders won’t lend to just anyone. If your credit score is too low, you won’t be able to qualify for any type of mortgage. Generally, lenders prefer borrowers with credit scores in the range of 580 to 660.
Applying for a subprime mortgage is pretty much the same as a conventional mortgage. You’ll need to provide plenty of documentation to show you can handle the payments, including a list of your bank accounts and other assets, any debts you currently owe, proof of your income via paystubs and tax returns.
What to Expect After You Apply
Once you submit your application and supporting documents, the lender will evaluate your financial situation and creditworthiness. They’ll look at your payment history, income and job history, DTI ratio and other factors. If you’re approved, the lender will provide you with a loan estimate that details the terms of the offer and lists out all associated fees. You can choose to accept the offer or negotiate different terms.