A subprime mortgage is generally issued to borrowers with low credit ratings. A prime conventional mortgage isn’t available in these cases because lenders consider these borrowers to possess a greater default risk. Consequently, lending institutions often charge much higher interest rates on subprime mortgages to compensate for this increased risk. These loans are frequently adjustable-rate mortgages (ARMs), meaning the interest rate can escalate at periodic intervals.
Key Takeaways
- Credit Risk: “Subprime” is indicative of a below-average credit score, suggesting potential credit risk.
- Higher Interest Rates: The elevated interest rate on a subprime mortgage compensates lenders for the higher risk of borrower default.
- Credit Score Threshold: Typically, borrowers with credit scores below 620 fall into the subprime category.
- Impact of 2008 Financial Crisis: The proliferation of subprime mortgages leading up to the 2008 crisis highlighted their risk.
- Stricter Regulations: Modern subprime mortgages come with more stringent underwriting processes.
Understanding Subprime Mortgages
“Subprime” doesn’t describe the high interest rates often linked to these mortgages but rather the low credit score of the borrower. Generally, a FICO score below 620 can result in having to resort to a subprime mortgage with a higher interest rate. Building up one’s credit history over time could allow such borrowers to qualify for prime loans instead.
The interest rate on a subprime mortgage hinges on four key factors: the credit score, the size of the down payment, the number of late payment delinquencies on the borrower’s credit report, and the types of delinquencies present. Consulting a mortgage calculator can be helpful in estimating the monthly payment impact of different interest rates.
Subprime Mortgages vs. Prime Mortgages
Borrowers typically receive mortgage ratings from A to F. Prime mortgages are offered to those with A or B ratings, indicating exemplary or good credit. Lower-rated individuals typically qualify only for subprime loans. Before resigning to a subprime loan, it’s wise to check if one qualifies for a prime mortgage.
Role in the 2008 Housing Market Crash
The 2008 housing market crash is widely attributed to defaults on subprime mortgages. An alarming aspect was the issue of NINJA loans—no income, no job, no assets. Many subprime borrowers ended up underwater, with loan amounts exceeding property values, facing skyrocketing payments over time.
Despite the financial crash, subprime mortgages continue to exist, evolving under new regulations and market dynamics.
COVID-19 Mortgage Relief
The Coronavirus Aid, Relief, and Economic Security (CARES) Act, along with the American Rescue Plan Act of 2021, offered mortgage relief provisions, including forbearance periods and funds for various housing necessities. Homeowners unable to meet mortgage payments were protected from foreclosure and received assistance in overcoming related financial challenges.
What Does a Subprime Loan Mean?
A subprime loan is any loan offered at a rate above prime due to the borrower’s higher perceived risk. It’s essentially the only avenue for individuals with low credit scores to access capital but comes at the expense of higher interest rates.
Differences Between Prime and Subprime Loans
The main difference lies in the interest rates. Subprime loans incur higher rates to mitigate borrower default risks. Given these differences, borrowers should compare offers from different lenders to find the least expensive subprime rates.
Who Offers Subprime Mortgages?
While most financial institutions are capable of offering subprime mortgages, specific lenders target these high-risk loans. Though providing access to capital, these often exponentially higher rates can significantly increase the overall interest paid.
Drawbacks of Subprime Loans
Subprime loans translate to higher costs over time, making repayment challenging for financially troubled borrowers. Criterion-loose lending also contributed significantly to the 2008-09 financial crises, highlighting systemic pitfalls.
Were Subprime Loans a Catalyst for the 2008-09 Financial Crisis?
Subprime mortgages are viewed as a substantial factor alighting the financial crisis. The crisis denotes complex interrelations among various stakeholders including financial entities, homeowners, regulation authorities, and investors.
The Bottom Line
Subprime mortgages cater to borrowers with low credit scores at higher rates of interest compared to prime loans. Building a better credit score before opting for a mortgage can prove advantageous, reducing long-term costs.
Related Terms: conventional mortgage, credit risk, FICO score, NINJA loans, forbearance.
References
- Federal Deposit Insurance Corporation. “Crisis and Response: An FDIC History, 2008-2013”, Page 1.
- Federal Deposit Corporation. “Interagency Guidance on Subprime Lending”.
- MyFico. “Prime vs. Subprime Loans: How Are They Different?”
- Consumer Financial Protection Bureau. “Borrower Risk Profiles”.
- Reuters. “Wells Fargo Edges Back into Subprime as U.S. Mortgage Market Thaws”.
- Neighborhood Assistance Corporation of America. “NACA Continues ‘Achieve the Dream’ Tour”.
- U.S. Congress. “H.R.748 - CARES Act”.
- U.S. Congress. “H.R. 1319: American Rescue Plan Act of 2021”.
