A subprime mortgage is designed for borrowers with poor credit scores or no credit history. With this type of credit rating, these borrowers would not qualify for a conventional mortgage. As a result, subprime mortgages are home loans that have a higher risk of defaulting.
Subprime mortgages usually come with more substantial fees, higher interest rates, greater closing costs, and a greater down payment. These upfront fees and higher interest costs help compensate lenders for approving a high-risk borrower.
Subprime lending makes buying a home more accessible to more people. However, the Consumer Financial Protection Bureau or CFPB has placed restrictions on subprime mortgages. Homebuyers must have an approved representative from the U.S. Department of Housing and Urban Development. Furthermore, subprime mortgages are now limited to how high their interest rate can increase.
The process for taking out a subprime mortgage is the same as a conventional mortgage. There is a loan application and a loan approval process that requires an underwriter.
You receive a subprime mortgage when a lender evaluates your level of risk based on your credit score, your debt-to-income ratio, your down payment, and your proof of income and assets. You can still get a loan, but these loans are considerably more costly than any other type of mortgage loan.
A subprime borrower is someone with a credit score below 660. Their credit report may show that they have had two more 30-day delinquencies in the past year, have declared bankruptcy in the last five years, or have had a foreclosure in the last two years. In many cases, lenders have had to write-off or write-down the loan or declare a judgment against the borrower in the previous two years.
These borrowers have a debt-to-income ratio of at least 50%. Additionally, a borrower is subprime of they have low income; specifically, their annual salary is less than half of the yearly total principal and interest payments.
Banks assess borrowers and assign each potential borrower a letter grade from A to F. This grade evaluates the borrower’s level of risk. Borrowers with an A grade qualify for a prime mortgage.
A prime mortgage is a conventional loan that has interest rates at least as low as the market prime interest rate offered by the Federal Reserve to banks. These loans meet the standards for quality mortgages dictated by Fannie Mae and Freddie Mac.
Qualified borrowers for a prime mortgage have a credit score of 680 or higher, a debt-to-income ratio maximum of 35%, a 20% down payment, and proper documentation of adequate income and assets. As a result, these borrowers will likely receive a competitive fixed interest rate.
Anything less than an A grade means you have more of a risk of defaulting on your loan. As a result, you may be considered a subprime borrower and qualify for interest-only mortgages, a dignity mortgage, a negative amortization loan, a balloon loan, or an adjustable rate mortgage.