What Is Subprime Mortgage in Home Loans

When you apply for a home loan, one of the critical factors that the lenders consider for assessing your eligibility is your credit history and current credit score. If your credit score is low or if you have a bad credit repayment history, the chances are high that the lender may reject your application. In such a situation, you can apply for a subprime mortgage. These loans are designed to suit the credit needs of people who have a bad credit history. Let us know more about it.

Home loan applicants who have a poor credit score or have negative items on their credit report are considered subprime. In comparison, the lenders consider prime borrowers as the ones that have a strong credit rating and sound financial track record. The lenders offer home loans at a lower interest rate to such borrowers.Today, many financial organisations use nonprime instead of subprime, but it means the same. Generally, lenders consider people with a credit score of 660 or less as subprime. Federal Deposit Insurance Corp suggests a person can be called a subprime mortgage loan borrower under the following situations:

• If the person has missed at least two EMI payments or were late in paying the amount by 30 in the last one year or paid the EMI late by at least 60 days in the previous 24 months.
• The individual has filed for bankruptcy in the last five years.
• The borrower has a high debt-to-income of 50% or more.
• The individual has experienced foreclosure, repossession in the last two years.

Just like the conventional home loan mortgage, there are different types of subprime mortgages, which are discussed below:

Fixed-rate mortgage

In this type of mortgage loan, the interest rate remains fixed for the entire mortgage term, and the borrower repays the same amount every month. One of the key differences between regular and fixed-rate subprime mortgages is that the latter comes with a higher repayment term; it can last for 40 – 50 years.

Adjustable-rate mortgage

Unlike a fixed-rate subprime mortgage where the interest rate remains fixed throughout the loan tenure, an adjustable-rate mortgage or ARM, the lenders offer the loan at a lower interest rate initially and reset the same as per the market index. Generally, the interest rate in ARM changes a few times after the introductory period gets over, and the lenders have a cap on the maximum interest rate.

Interest-only mortgage

As the name suggests, when the borrower repays the interest-only loan, the entire amount goes towards repayment of the accumulated interest for the first 7-10 years. Later, after the initial period, the payments go towards repaying the principal and the interest component.

Dignity mortgage

This is a unique type of mortgage that is a combination of subprime and a conventional mortgage. In this mortgage, the borrower puts down about 10% and agrees to pay a higher interest for the first few years (usually five years). And, if they make all the payments on time, the lenders revise the interest and lower it to the prime rate, i.e., the interest rate charged to the creditworthy customers.

High-interest rate

Since the subprime mortgage borrowers have a poor credit score , the lenders take a high risk in offering home loans to such customers as the chances of non-repayment are high compared to a traditional mortgage. So, to mitigate that risk, the lenders usually charge a higher interest rate on subprime mortgages.For example, the lenders may offer a traditional fixed mortgage for 30 years at an interest rate of 3%. In contrast, the interest rate for a subprime mortgage borrower can be about 8% to 10% or more.

Larger down payment

Another common tactic the lenders use to offset the risk of subprime mortgages is asking the subprime borrowers to make a larger down payment of about 35% of the home value. The percentage of the down payment that the borrowers must make may vary based on the type of loan they want to avail.Paying such a high down payment can be challenging for the subprime borrowers, especially if the value of the property they want to buy is high. In such cases, the borrowers must be careful about paying such a large amount upfront as it may strain their savings. Also, in the event of any emergency in the family, the borrowers may struggle to cover the expenses while managing the home loan repayments.

Higher payments

Since the subprime mortgage borrowers must pay a higher interest rate, it is vital such borrowers don’t borrow more than they can afford to repay. And suppose the financial condition changes like the borrower face situations like a sudden job loss or a medical emergency in the family. In that case, the high payments may become too much to handle. Missing even a single mortgage payment can severely impact the borrower’s credit profile. In the worst case, it may trigger a foreclosure.

Longer repayment term

This is perhaps one of the few benefits of a subprime mortgage. The repayment terms are generally higher than conventional mortgages. The borrower can stretch the repayment term for 40 to 50 years. While such long repayment tenure may reduce the monthly mortgage payment, you would have to bear the repayment liability for a more extended period. Also, when you repay the interest for a more extended period, the overall loan cost increases dramatically.

For individuals who have a poor credit score and bad credit history, applying for a subprime mortgage is one of the options to get a mortgage loan. However, it is not the only option one has. Borrowers may also consider applying for government-backed mortgage facilities like the Federal Housing Administration.These loans offer mortgages at a lower interest rate and require lower down payments than a subprime mortgage. Also, if you are self-employed and don’t have taxable income, you can consider applying for a subprime mortgage.

A subprime mortgage is an excellent way for people with bad credit history to get a loan for home purchase. However, the high-interest rate, down payment may make it harder for people to afford to repay the loan. So, borrowers must assess their financial conditions before signing up for the type of loan.

The information contained herein is generic in nature and is meant for educational purposes only. Nothing here is to be construed as an investment or financial or taxation advice nor to be considered as an invitation or solicitation or advertisement for any financial product. Readers are advised to exercise discretion and should seek independent professional advice prior to making any investment decision in relation to any financial product. Aditya Birla Capital Group is not liable for any decision arising out of the use of this information.