The Pros and Cons of Subprime Mortgages

Who Is a Subprime Borrower?

Lenders may categorize subprime borrowers as those with FICO^® Scores^☉ below 670, but this credit score cutoff can vary by company. Other measures of creditworthiness, such as income and other debts, can also be used to assess a credit applicant's eligibility for credit.

One thing lenders do agree on is that candidates for subprime mortgages are more likely to miss payments or default on their loans than borrowers with better credit. And because subprime borrowers are seen as greater repayment risks, lenders typically charge them higher interest rates and fees.

What Is a Subprime Mortgage?

Subprime mortgages are home loans designed for and marketed to borrowers with lower credit scores and poor credit histories. These loans are considered a driver of the subprime mortgage crisis that devastated the housing market from 2007 to 2010. These days, subprime loans come with more government regulations than before the housing crisis.

All subprime mortgages have a couple of attributes in common, each designed to minimize the risk of lending to riskier borrowers.

• High closing costs: Lenders offset the risk of lending to riskier borrowers with poor credit by collecting high upfront payments. Origination fees of 10% or more were not uncommon before the financial crisis, but regulations have dialed them back.

• High interest rates: Rates on subprime mortgages are typically several points higher than those on conventional mortgages—a difference that can cost you tens of thousands of dollars over the lifetime of the loan.

Types of Subprime Mortgages

Here are four types of nonconventional subprime mortgages you may encounter if your credit is less than optimal:

• Adjustable-rate mortgages (ARMs): By far the most common subprime home loan is the adjustable-rate mortgage. ARMs typically start with a lower rate before shifting to a "floating" rate that is tied to a market index, such as the London interbank offered rate (Libor). This shift can increase monthly payments significantly, straining household budgets and adding significant unpredictability to home finances. These factors contribute to the relatively high default rates typical of subprime mortgages.
• Extended-term mortgages: These loans have repayment periods of 40 years (480 months) or even 50 years (600 months) instead of the 30 years (360 months) associated with conventional mortgages. While longer terms typically lower your monthly payment, having a repayment term that's decades longer than a conventional mortgage could cost you tens or even hundreds of thousands of dollars over the lifetime of the loan.
• Interest-only mortgages: With an interest-only mortgage, the borrower has the option, during the initial part of the repayment period (typically three to 10 years), to pay only the interest due on the loan (without paying back principal). At the end of this intro period, the borrower can renew the loan or refinance and begin paying down the principal. This type of mortgage tends to work best for borrowers who make full principal-and-interest payments each month and use interest-only payments only as an emergency option.

Pros of a Subprime Mortgage

Critics of subprime mortgages often cite their involvement in the housing crisis, high interest rates and lax lending requirements, but they're not all bad. In fact, they can provide opportunity to borrowers who may have few other options. Among the benefits of getting a subprime mortgage are:

• An avenue to homeownership: Subprime loans give people with lower credit scores the opportunity to own a home without spending years trying to build or repair their credit.
• Potential credit score boost: Making regular on-time mortgage payments will help you build a positive payment history, which is the most important factor in credit scoring. Your payment history makes up 35% of your FICO^® Score, the score used by 90% of top lenders.
• Capped rates: Fortunately, government regulations have set a limit on interest rates for subprime mortgages, and lenders must comply with those rules.

Cons of a Subprime Mortgage

Aside from the repayment term, fees and benefits of a subprime mortgage, you should also understand the inherent risks, including:

• Higher interest rates: Lenders offset the risk of lending to borrowers with poor credit and other financial difficulties by charging higher interest rates. Rates on subprime mortgages can be up to 8% to 10% higher than rates for prime mortgages, those reserved for a lender's most highly qualified borrowers.
• Higher costs upfront: Down payments, closing costs and fees tend to be significantly higher with subprime loans. For example, lenders may require down payments 25% to 35% higher with their subprime mortgages. They aim to receive as much money upfront as possible to offset the higher risk of default with a riskier borrower.
• More expensive in the short and long term: With a higher interest rate on your subprime mortgage, you'll face the burden of a higher payment each month. And if you have a 40- or 50-year repayment term, you could end up paying substantially more in interest over the life of the loan.

Should You Get a Subprime Mortgage?

If your only route to owning a home is by getting a subprime mortgage, you might consider applying for one. But be aware that high upfront costs, steep interest rates and the unpredictable nature of ARMs can make subprime mortgages perilous for many borrowers.

Before you apply for a subprime mortgage, consider other loans that help borrowers with lower credit scores or income.

• Federal Housing Administration (FHA) loans: Generally, FHA loans feature lower interest rates than conventional mortgages. You may be eligible for an FHA loan with a credit score as low as 500 with a 10% down payment or 580 with a 3.5% down payment.
• Veterans Affairs (VA) loans: You may be able to purchase a home with little or no money down with a VA loan. To qualify for a VA loan, you must be a qualified veteran or member of the military community, such as a spouse or other beneficiary.
• U.S. Department of Agriculture (USDA) loans: You don't need a down payment to qualify for a USDA loan. These loans seek to help homebuyers with limited income purchase a home in eligible rural areas.

Subprime mortgages aren't for everyone, and in an ideal world, you'll find a less expensive and risky option. If you're not in a rush for housing, a better idea is to improve your credit so you can qualify for a prime mortgage. Consider using nonprofit credit counseling services to help in this effort.