A subprime mortgage is a type of housing loan granted to individual with a poor credit score – 640 or less (and even below 600) – who, as a result of their poor credit rating would not qualify for more conventional mortgages. The term subprime itself is referring specifically to the borrower’s credit score – thus their ability to pay back their financial obligation – rather than the financial agreement embedded in the loan itself. Subprime borrowers are implicitly more likely to default than others with a higher credit score.
Types of Subprime Mortgages
In essence, subprime mortgages are mortgages given to subprime borrowers. The main types of subprime mortgages include fixed-rate mortgages with 40- to 50-year terms, interest-only mortgages, and adjustable rate mortgages (ARMs).
Fixed-Interest Mortgages
One type of subprime mortgage is a fixed-rate mortgage, given for a 40- or 50-year term, in contrast to the standard 30-year period. This lengthy loan period lowers the borrower’s monthly payments, but it is more likely to be accompanied by a higher interest rate. The interest rates available for fixed-interest mortgages can vary substantially from lender to lender. Higher interest rates over a lengthy period of time means the borrower will be under constant pressure to meet their monthly obligations over a prolonged period of time; additionally, it means that the lender will gain a lot of interest of their principal if the loan is paid off.
Adjustable-Rate Mortgages
An adjustable-rate mortgage starts out with a fixed interest rate and later, during the life of the loan, switches to a floating rate. One common example is the 2/28 ARM. The 2/28 ARM is a 30-year mortgage with a fixed interest rate for two years before being adjusted. Another typical version of the ARM loan, the 3/27 ARM, has a fixed interest rate for three years before it becomes variable.
In these types of loans, the floating rate is determined based on an index plus a margin. A commonly used index is ICE LIBOR. With ARMs, the borrower’s monthly payments are usually lower during the initial term. However, when their mortgages reset to the higher, variable rate, mortgage payments usually increase significantly. Of course, the interest rate could decrease over time, depending on the index and economic conditions, which, in turn, would shrink the payment amount.
According to CNN Money’s Les Christie, “ARMs played a huge role in the crisis”. When home prices started to drop, many homeowners understood that their homes weren’t worth the amount the purchase price. This, coupled with the rise in interest rates led to a massive amount of default. This led to a drastic increase in the number of subprime mortgage foreclosures in August of 2006 and the bursting of the housing bubble that ensued the following year.
Interest-Only Mortgages
The third type of subprime mortgage is an interest-only mortgage. For the initial term of the loan, which is typically five, seven, or 10 years, principal payments are postponed so the borrower only pays interest. He can choose to make payments toward the principal, but these payments are not required.
When this term ends, the borrower begins paying off the principal, or he can choose to refinance the mortgage. This can be a smart option for a borrower if his income tends to fluctuate from year to year, or if he would like to buy a home and is expecting his income to rise within a few years.
Dignity Mortgages
The dignity mortgage is a ‘new type of subprime loan’, in which the borrower makes a down payment of about 10% and agrees to pay a higher rate interest for a set period, usually for five years. If he makes the monthly payments on time, after five years, the amount that has been paid toward interest goes toward reducing the balance on the mortgage, and the interest rate is lowered to the prime rate.
What Exactly is a Subprime Mortgage?
