A borrower's FICO score and the loan-to-value ratio determine the type of mortgage a borrower will qualify for. In general, low FICOs along with high ratios (such as 100% financing of the home purchase) result in something known as a subprime loan. A subprime loan has a higher interest rate than a conventional mortgage for a higher rated borrower.
Prior to 2007, lenders routinely made subprime mortgages to borrowers with a FICO score of less than 620. In many cases, borrowers with a FICO score of just 580 could qualify for 100% financing. After the financial crisis, subprime loans became harder to qualify for. Today, virtually no lender provides 100% financing to subprime borrowers, except for VA loans.
Subprime mortgages are granted to individuals with poor credit who cannot qualify for conventional mortgages. Given the higher risk for lenders, these mortgages typically have higher interest rates. There are several types of subprime mortgages available, but the most common is an adjustable rate mortgage (ARM), which has an initial fixed interest rate.
ARMs can be misleading to subprime borrowers, as they will initially pay a lower interest rate. When the mortgage resets to a new variable rate, the mortgage payments can increase dramatically.
Subprime mortgages may also be balloon loans, or a combination of an ARM and a balloon loan. A balloon mortgage has a lump sum due at the end of the loan term, which is usually a large percentage of the total amount of the loan.
Considerations before Getting a Subprime Loan
- You are not required to take a subprime loan, just because a lender has offered one to you. You may qualify for an FHA loan instead. See below to learn more.
- Prepayment penalties associated with the loan may make it difficult to refinance or obtain a new loan later to pay off the first loan.
- In some cases, it may make sense to obtain a subprime loan if you have the ability to improve your financial or credit situation to later refinance. A subprime loan can also make sense if you do not plan to remain in the home for long.
Subprime Mortgage Lending Is Increasing
For several years after the housing crash, subprime mortgages all but disappeared. Lenders have started to increase subprime lending; however, discovering that many consumers who went through a short sale or foreclosure are a good risk and willing to pay a higher rate and fees to obtain financing while home prices are still affordable.
Some people who obtain subprime loans with high rates view them as bridge loans, which are short-term loans used until permanent financing is secured. Today's subprime mortgages are different than those made during the housing boom in several ways, as collateral, down payment, income and ability to pay matter. These new loans are, in many ways, safer than subprime loans, made just six years ago as lenders perform a thorough analysis to make sure borrowers can afford the mortgage payments, and are not buying more home than they can afford.