Pros and Cons of Subprime Mortgages

What Are Subprime Mortgages?

Subprime mortgages are home loans for borrowers with subprime credit scores. As a general rule, a subprime borrower has a FICO^® Score below 670 or a VantageScore^® credit score of 600 or lower. Keep in mind, credit score standards may still vary among lenders.

Lenders compensate for their perceived risk of lending to low-credit borrowers by charging interest rates several points higher than those on conventional mortgages. This makes subprime borrowing more expensive overall, even on smaller loan amounts.

Example: On a $450,000 30-year fixed mortgage, a 2% higher interest rate may add over $600 to your monthly payment and roughly $220,000 in total costs over the life of the loan, though the exact costs will vary based on your rate and loan terms.

Subprime lenders also offset risk by collecting high upfront payments. Fortunately, government regulations have largely reined in exorbitant origination fees, which were commonplace during the subprime mortgage crisis of 2008.

Tip: When shopping for a mortgage, run the numbers for each loan offer through a mortgage calculator to compare how different mortgage rates could impact your monthly payment.

Learn more: What Is a Subprime Mortgage?

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Types of Subprime Mortgages

Here are four of the most common types of subprime mortgages that may be available to you if you don't qualify for a conventional or government-backed mortgage.

• Adjustable-rate mortgages (ARMs): While not always geared to subprime borrowers, ARMs are the most common subprime home loan structure. ARMs typically start with a lower rate before transitioning to a floating rate that is tied to a market index, such as the Secured Overnight Financing Rate (SOFR). ARMs can be risky due to payment shock: After the initial low fixed-rate period, your interest rate and monthly payment can increase, sometimes significantly.
• Extended-term mortgages: While conventional loans typically run for 15- or 30-year terms, extended-term mortgages have repayment periods of up to 40 or even 50 years. While longer terms typically lower your monthly payment, stretching payments over an extra 10 or 20 years could increase your total interest costs by tens or even hundreds of thousands of dollars, depending on your loan amount and rate.
• Interest-only mortgages: An interest-only mortgage is unique in that it splits the repayment term into two phases. During the loan's first three to 10 years, you make interest-only payments on the loan principal. Once this initial phase ends, the loan begins a fully amortizing phase, and your payments include both principal and interest. At that point, you may want to check your eligibility to refinance the loan, as the annual percentage rate (APR) and origination fee on interest-only mortgages are generally higher than those for conventional mortgages.
• Dignity mortgages: These mortgages are a combination of a subprime mortgage and a conventional home loan. They're designed for borrowers who expect to improve their creditworthiness for a mortgage in the future. You typically put down about 10% and pay a higher interest rate for a set period, often five years. If you make on-time payments during that time, the extra interest you paid is applied to your loan balance and your rate resets to a conventional level.

Pros of Subprime Mortgage

Subprime mortgages may have a lingering bad reputation due to their role in the housing crisis and high interest rates. But they do have some advantages, and can make sense in some situations.

Path to Homeownership

Subprime loans help low-credit borrowers who otherwise would not qualify for a mortgage to have the opportunity to own a home. Qualified subprime borrowers can purchase a home without spending years trying to build or repair their credit.

Potential Credit Score Boost

Borrowers with poor credit may improve their credit standing by making regular on-time mortgage payments. Building a positive payment history is the most important factor in credit scoring, making up 35% of your FICO^® Score. By improving your credit score, you may qualify to refinance into a conventional mortgage with a lower rate.

Learn more: How Does Refinancing a Mortgage Work?

Stronger Protections

While the government doesn't set a hard cap on interest rates, regulations provide significantly stronger protections than those found during the 2008 housing crisis, such as:

• Ability-to-repay rule: This Consumer Financial Protection Bureau (CFPB) rule requires lenders to verify that a borrower can reasonably afford the mortgage before approving it. This makes it harder for lenders to offer no-doc mortgages or predatory loans that contributed to the mortgage crisis.
• ARM interest rate caps: Lenders are now limited in how much they can raise a payment when adjusting the interest rate.
• High-cost trigger: If a mortgage rate is more than 6.5% to 8.5% higher than the current prime rate, it triggers Home Ownership and Equity Protection Act (HOEPA) protections. These loans undergo strict legal scrutiny, and the borrower must agree to mandatory credit counseling, which makes it harder for lenders to push them.

Cons of Subprime Mortgage

While subprime home loans can benefit you, there are risks you must consider before proceeding with one.

Higher Interest Rates

Subprime lenders offset their risk by charging higher interest rates. Rates on subprime mortgages can be up to 10% higher than rates for prime mortgages, those reserved for a lender's most highly qualified borrowers.

Higher Costs Upfront

Some lenders may also require a larger down payment of up to 25% or even 35%, though others may only require 10% to 20% down. In some cases, a larger down payment could replace a higher rate or ease other requirements. These loans also come with closing costs and fees that tend to be significantly higher than those on conventional loans.

Learn more: How Your Down Payment Affects Your Mortgage

Longer Timeframe to Build Equity

With amortized loans like mortgages, most of your payment goes toward interest in the early years, as lenders seek to recover their costs and reduce risk upfront. It's not until the end of the loan that the majority of your payment is applied to the principal. This process is more gradual with an extended-term mortgage, so it takes longer to build equity in your home.

Who Should Consider a Subprime Mortgage?

Subprime mortgages generally shouldn't be considered if you qualify for a prime rate. However, they can be a viable option for:

• Homebuyers unable to qualify for conventional or government-backed mortgages: Subprime loans are an option for potential homebuyers who are shut out of conventional financing. If your credit score is too low, your debt-to-income ratio is too high or your income is hard to document, a subprime mortgage may be one of the few ways to finance a new home.
• Buyers willing to accept higher costs: If you don't mind taking on a higher interest rate and fees, a subprime mortgage can help you buy now instead of waiting to qualify for better terms.
• Borrowers working to rebuild their credit: If you've had a recent bankruptcy, you may need to wait one to four years before you can apply for conventional or government-backed loans. A subprime loan could help you finance a home while you rebuild your credit.
• Buyers planning to refinance later: A subprime mortgage may make sense if you're looking for a short-term solution, and you anticipate refinancing into a lower-rate mortgage once your credit and financial situation improve. Making consistent, on-time payments over time can strengthen your credit and help you qualify for more favorable loan terms.
• Self-employed borrowers with hard-to-document income. If you're self-employed and can't easily verify income with W-2s or traditional pay stubs, qualifying for a conventional loan can be difficult. A subprime mortgage may allow you to qualify using other documentation, such as bank statements.

Alternatives to Subprime Mortgages

If your credit history is making it difficult to qualify for a conventional mortgage, you may still qualify for other non-prime home loans. Depending on your financial situation, you may qualify for one of the following options.

• Manual underwriting: Most lenders rely on automated processes to make approval decisions within their eligibility guidelines. If your conventional mortgage loan is denied, ask the lender if they offer manual underwriting, where a human takes a closer look at your credit and financial information. You may be able to show creditworthiness using on-time rent and utility payments and verify income with bank statements or profit and loss statements.
• FHA loans: If you don't meet credit standards for a conventional loan, it may be worth looking into a loan backed by the Federal Housing Administration (FHA). You may qualify with a credit score as low as 500 if you can swing the 10% down payment. Otherwise, you must have a 580 or better credit score with a down payment as low as 3.5% of the loan amount.
• VA loans: The Department of Veterans Affairs (VA) backs VA loans for eligible military service members and their families. The primary benefit of these home loans is that they don't require a down payment or a minimum credit score, though lenders often look for scores of at least 620 to 670.
• USDA loans: You may be eligible for a loan guaranteed by the U.S Department of Agriculture (USDA) if you're buying a home in a rural area. These mortgages also don't require a down payment or minimum score. Again, lenders may have their own credit score requirements, so check with your lender before applying.

Learn more: What Is a Government-Backed Mortgage?

Frequently Asked Questions

The Bottom Line

Subprime mortgages have a murky reputation after their role in the 2008 housing crisis. Some of it is well-earned, given the high interest rates, fees and down payments they require. These factors may increase the risk of default. But they do offer borrowers with poor or fair credit the chance to buy a home when they can't qualify for a prime mortgage.

If you can wait, it may be wise to take some time to improve your credit before applying. Check your Experian credit report and FICO^® Score for free to see where your credit stands. Verify the information in your report is accurate, and understand you have the right to dispute any incorrect information. By taking steps now to improve your credit, you may qualify for a prime mortgage with a lower interest rate.