If your credit history is stopping you from getting a conventional mortgage, you may think a subprime mortgage is a good idea. But before you sign the dotted line, let’s look closer at subprime mortgages and see how they work.
What is a Subprime Mortgage?
A subprime mortgage is a housing loan given to people with less-than-perfect credit. They were designed to bring the American Dream of homeownership within everyone’s reach—and when we say everyone, we mean, like, everyone: whether you filed bankruptcy last year, have a low income, or have a long history of not paying your bills, you could qualify for a subprime mortgage—crazy, right?
How do Subprime Mortgages Work?
You take out a subprime in the same way you’d take out a conventional mortgage—through a lender like a bank or mortgage company.
The biggest difference between a conventional and subprime mortgage is the interest rate. Because a subprime borrower poses a greater threat to the lender, the lender charges a higher interest rate per month. This means, in the long run, you’ll pay more for your house than you would through a conventional mortgage.
What is the Borrower Classification?
Lenders have their own way of assessing borrowers for risk. Basically, they assign each potential borrower a "grade" that stands for the borrower’s level of risk. The highest grade is the "A-paper" and usually means the borrower has all of the following:
- A credit score of 680 or higher
- A debt-to-income ratio that isn’t above 35%
- A 20% down payment
- Documentation of income and assets.
If you’re issued an "A-paper," you won’t get a subprime mortgage. You’ll get a conventional mortgage, a prime mortgage, with a fixed interest rate that’s much lower than the subprime’s rate.
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If you don’t qualify for an A, you’ll get a lower grade: a "B, C, or D-paper." A "B-paper" is less risky than a "C-paper," and a "C-paper" is less risky than a "D." All three are considered subprime mortgages, and they’re issued to borrowers with these traits.
- A credit score below 660
- Trouble paying month-to-month living expenses
- Debt-to-income ratio of 50 percent or more
- Bankruptcy in the last 5 years
- Foreclosure in the last 2 years
What are the Types of Subprime Mortgages?
Subprime mortgages come in several different forms, but these five are the most common.
1. Interest-Only Mortgages
Consider, for a moment, how a conventional mortgage works. Let’s say you take out a 15-year mortgage with a fixed interest rate. That means, for 15 years, you pay a fixed monthly payment that’s part-loan balance and part-interest. Simple, right?
An interest-only mortgage, however, requires you to pay only interest for a fixed amount of time, usually somewhere between 5 and 10 years. If you’re paying only interest, your monthly payments will be much lower than the payment on a conventional mortgage—lower, sure, until the interest-only time frame ends.
Once the time frame ends, you’ll have to pay interest and your loan balance. And here’s the catch: you won’t get extra time to pay off your mortgage. So, if you took out a 15-year mortgage, with a 5-year interest-only time frame, you have 10 years to pay the entire loan balance plus interest!
2. Dignity Mortgage
Dignity mortgages are a new type of subprime. Like the original subprime mortgage, you pay a higher than normal interest rate. Then, after five years of paying your mortgage on time, your interest rate is reduced to the standard rate. And all that "extra" money you’ve paid in interest will go toward your loan balance. From that point on, your interest rate will be the same as a conventional mortgage.
3. Negative Amortization Loans
Positive amortization is the way a mortgage should work. You pay both the interest and a portion of the loan balance and slowly the amount you owe drops. Your loan is amortizing—it’s slowly dying out.
Negative amortization is the opposite. You can’t pay enough to cover the interest, which means every month that loan balance grows and grows and grows.
For example, let’s say you take out a $150,000 mortgage with a 7% interest rate. Every month, you’d pay $875 in interest (.07/12 months x 150,000 = $875). Now, let’s also say your lender has agreed to let you pay only $500 a month, which means every month, you leave unpaid $375 in interest. What happens to that $375? Your lender adds it to your loan balance, raising it to $150,375. If this happened every month for a year, you’d have a loan balance of $154,500, and if this happened for five years, your loan balance would be $172,500!
When a lender gives you a negative amortization loan, you’ll have a time frame in which you pay a portion of the interest. But no lender wants your loan to grow forever! Eventually, they’ll raise your monthly payments, and you’ll have to pay all of the interest and a portion of the loan balance.
4. Balloon Loans
Think about how a balloon works. A balloon starts with a tiny width, expands slowly as you breathe air into it, then puff stretches to its full size.
That’s a balloon loan in a nutshell! When you take out a balloon loan, you make very small payments for a long time. Small payments, however, mean you owe more on your loan balance, and eventually you make one giant payment to repay the whole loan.
So, let’s say you take out a 5-year balloon loan for a $250,000 house. Let’s also say that every month you pay $1,000 of the loan balance. After 5 years, you’ll have paid $60,000 of your loan, which means you still owe $190,000. Once your 5-year loan period is up, you’ll make one small payment of $190,000. All. at. once.
5. Adjustable Rate Mortgage (ARM)
With a conventional mortgage, your interest rate stays the same. Adjustable rate mortgages (ARMs), however, have interest rates that change, sometimes by a really large amount!
ARMs always start with a "grace" period with a fixed interest rate—what some lenders call the "teaser." You may have a teaser of two years, or five, or 10, during which you pay the same interest rate, year after year. Then, when the teaser ends, your interest rate becomes variable. One year your interest rate could be very low, the next year, extremely high.
ARMs can pose a major threat to borrowers. Since borrowers can’t predict which way the interest rate will go—up or down—they could easily find themselves owing far more than they can afford. And if this happened on a large scale, if millions of borrowers found themselves unable to repay the mortgage, we could have a major economic crisis.
At least, that’s how the subprime mortgage meltdown started.
What was the Subprime Mortgage Meltdown?
Back in the early 2000’s, people were getting subprime mortgages like candy on Halloween. Most of these subprime mortgages were ARMs, and because at that time interest rates were at a historic low, many broke people thought they could afford the loan.
On top of low interest rates, property values were soaring. Most lenders didn’t even care if borrowers couldn’t pay off their mortgages. If they couldn’t repay, lenders would just take back the property, sell it for a higher price, and make some profit.
So lenders gave loans to everyone.
No income? No worries, take a loan!
No job? Take a Loan!
No assets? Loan!
Then, in 2006, the unexpected happened. For the first time in nearly a decade, home prices dropped and interest rates rose. And the ARMs, which had helped so many broke borrowers buy homes, started to kick-in—suddenly, subprime borrowers found they couldn’t afford the higher interest rates. They had to default, which means they forfeited their houses to the banks.
In a good housing market, banks would have made a lot of profit. But by 2007, nobody wanted to buy a houses and property values were plummeting. Banks had no choice but to sell the properties at a lower price. They lost money, became weak, and that’s when the banking world went under.
Should you take out a Subprime Mortgage?
Since 2007, the housing market has finally strengthened. Did we learn our lesson? Well, not exactly. Lately, subprime mortgages have been making a comeback. Lenders give these resurrected subprime mortgages new names—like the dignity mortgage—but under the name change, you’ll find the same product: a risky mortgage with a higher interest rate.
If you’re thinking about taking out a subprime mortgage, stop and ask yourself these three questions.
1. Are you truly ready to buy a home?
You may be mentally ready, sure, but unless you’re financially ready, you shouldn’t take out a mortgage, subprime or not. Remember: you want to own your home instead of your home owning you! If you need to go the mortgage route, make sure you have these basics covered:
- You’re completely debt-free
- You have three to six months of expenses saved in an emergency fund
- You’ve saved at least 10–20% of the down payment already (20% is ideal so you avoid private mortgage insurance (PMI) payments)
- Your mortgage payment is no more than 25% of your take-home pay
If you haven’t covered these basics, you’re not ready to buy a home. And though you could technically qualify for a subprime mortgage, you’re borrowing more than you can safely repay.
2. Do you want to take on the extra risk?
Be honest with yourself. If you haven’t paid credit well in the past, what makes you think you can do it now? Your lender won’t think twice before taking your house if you start missing payments. And if you thought you had trouble buying a home with bad credit, imagine trying to buy a home after you’ve defaulted!
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3. Do you really want to pay that much more for a house?
On the surface, a subprime mortgage looks like a humanitarian effort to help underprivileged people get homes.
But when you look closer, you’ll discover that you’re really paying more for a house. And by more we mean a lot more. You’re paying a higher interest rate, higher closing costs, and most of the time, you’re paying your loan over a longer period of time. Your lender is getting the great deal. And you? Not so much.
For example, let’s say Buyer Bob wants to buy a $250,000 home. He takes out a 30-year interest-only mortgage (a subprime) with a 7% interest rate. Let’s use our mortgage calculator and break his final cost into steps.
- Every month he would pay $1458 in interest (.07/12 x $250,000)
- The first 10-years, he pays only interest, which comes out to $174,960 ($1458 x 12 months x 10 years).
- After the 10-year period, he must pay the loan balance, $250,000, over a 20-year period.
- After 20-years of paying the loan balance, he ends up paying $349,920 in interest.
- At the end of his 30-year mortgage he would pay $774,880.
Now, let’s say Buyer Joe also wants to buy a $250,000 home on 30-year conventional mortgage with a fixed interest rate of 4.50%. How much would he pay?
- Buyer Joe would pay around $937.5 a month in interest (.045/12 x $250,000).
- After 30 years, he would pay $337,500 in interest.
- At the end of his 30-year mortgage, he would pay $587,500 for his home.
In sum, Buyer Bob pays $187,380 more on a subprime mortgage than Buyer Joe—and that’s only the difference in interest.
Now, let’s compare these with Buyer Jane, who decided to follow Dave’s advice and buy that same $250,000 home on a 15-year conventional mortgage with a 4.25% fixed interest rate. What does she pay?
- Every month, she pays $885 in interest (.0425/12 x $250,000)
- After 15-years, she pays $159,375 in interest.
- At the end of the 15-year mortgage, she pays $409,375 for that house, $178,125 less than Buyer Joe’s 30-year conventional mortgage and $365,505 less than Buyer Bob’s subprime mortgage!
Get a Mortgage the Right Way
How can you be like Buyer Jane and pay significantly less for a home?
If you’re ready to buy a house, but you have a bad credit history, you don’t have to take a subprime mortgage. You just need to work with a lender like Churchill Mortgage that still does manual underwriting, a process in which a lender reviews your loan application and determines if they can trust you to repay the loan.
If your credit score is scaring you into taking out a subprime mortgage, pay a visit to our friends at Churchill Mortgage. The financial experts there have helped hundreds of thousands of people plan smarter and live better. Before you commit to a subprime mortgage, ask Churchill to help you find the right answers for your specific situation!