By Motley Fool. April 21, 2015, 09:09:02 PM EDT
A subprime mortgage generally refers to a mortgage loan made to a borrower with a low credit score. While not as common as they once were, subprime mortgages are slowly making a comeback in the housing market today.
Who is a subprime borrower?
Basically, any borrower unable to obtain a conventional mortgage loan because of credit reasons is a subprime borrower. Different banks have different "cut-off" credit scores they use to define subprime, but a credit score below 640 is generally viewed as subprime.
Subprime mortgages before the financial crisis
Before the financial crisis in 2008, subprime lending made up a large chunk of the mortgage market. According to one report, 29% of new mortgages in 2004 were subprime, compared with just 0.3% in 2013.
Back then, deceptive lending practices were rather common, as were certain types of "exotic" loans that simply don't exist anymore, at least in the form they once did. For example:
- Interest-only loans: Borrowers paid only the interest on their loans for a certain number of years, and the principle didn't change. These were extremely common pre-crisis, as they let borrowers afford more expensive homes. They are still around today, but they aren't nearly as common as they used to be and generally require an outstanding credit history.
- Option ARM loans: These loans gave borrowers a period of time (say, five years), during which they could choose what amount to pay. If they paid less than the interest on the loan, it was added to the principle.
- Negative amortization loans: Payments on these loans were so low they didn't even cover the interest, so the principle actually grew over time. Since these types of loans depended on home price appreciation in order to make sense, they were discontinued after the real estate market started to fall.
- Longer-term fixed-rate mortgages: Before the Financial Crisis, it wasn't uncommon to see 40- or 50-year fixed-rate mortgage terms. These still exist but are generally considered a bad deal for both the lender and the borrower, so they're pretty rare.
- Balloon loans: These were loans that required low payments for a few years, after which the entire balance was due.
- No-money-down loans: Yup, there was a time when 100% financing was rather easy to obtain.
The current state of
subprime mortgage lending
Exotic and zero-down mortgage options are a thing of the past. And while subprime mortgages are still around, they look very different than they did before the real estate crisis.
Today's subprime mortgages are far from exotic. In fact, they look almost identical to conventional fixed-rate or adjustable-rate loans. They have similar (if not stricter) down payment, income, and employment requirements. And for a measure of security, subprime mortgages come with higher interest rates in order to compensate the lender for the additional risk.
Examples of subprime mortgage terms:
- A borrower with a credit score between 550 and 599 could qualify for a loan requiring a 30% down payment and charging 9.75% interest.
- Bloomberg recently reported that a borrower who was unable to qualify for a "prime" mortgage because his income fluctuated too much obtained a subprime loan with an 8.75% interest rate.
While the interest rates on these loans are very high compared with the average 30-year mortgage rate, for many people, getting a subprime mortgage is the only path to homeownership.
Borrow on your terms
Subprime mortgages may be the only option for some aspiring home owners, but that doesn't mean they're always a good idea.
With high interest rates, you might be better off renting. So do the math and make sure you take a long look at all of your options before deciding whether or not a subprime mortgage is right for you.
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The article What Is a Subprime Mortgage? originally appeared on Fool.com.
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