What is a subprime mortgage? – Councilor Forbes
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If you’ve dreamed of owning a home, but bad credit is preventing you from making it a reality, a subprime mortgage might be a better option. Although these loans are designed for high risk borrowers, they come with certain risks.
Here’s what you need to know before considering a subprime mortgage.
Who are the subprime mortgage borrowers?
Mortgage applicants with bad credit scores and negative items on their credit reports are often considered subprime. While prime borrowers have good credit and a solid financial history, therefore, the lender is more likely to offer them a loan at a lower interest rate.
Today, financial institutions often use the term non-prime instead of subprime, but the meaning is the same. Usually this is defined as a borrower with a credit score of 660 or less. According to the Federal Deposit Insurance Corp (FDIC), an at-risk borrower is also someone who:
- Has had at least two 30-day late payments in the past 12 months, or at least one 60-day late payment in the past 24 months
- Has undergone a judgment, foreclosure, repossession or expungement in the past 24 months
- Filing for bankruptcy in the last five years
- Has a debt-to-income ratio (DTI) of at least 50%
Home loans designed for these types of high risk borrowers are considered subprime or subprime mortgages.
The term subprime may sound familiar thanks to the subprime crisis. Prior to 2008, mortgage lenders had much more flexible standards for approving borrowers with poor credit scores and financial histories. These were also sometimes referred to as no doc loans because some lenders did not require documented proof of income.
Eventually, many of these borrowers defaulted on their loans. Between 2007 and 2010, foreclosures skyrocketed and banks lost tons of money, forcing the government to bail out many large banks, while others merged or were sold following bankruptcy.
In response to the subprime mortgage crisis, the Dodd-Frank Act of 2010 was established to revise financial regulations to avoid a similar crisis in the future. The law includes a requirement from the lender called the Repayment Ability Rule (ATR). This rule requires mortgage lenders to establish a thorough process to assess whether a borrower is able to repay the loan on their terms, thus ending the practice of doc-less mortgages.
The lenders must also guarantee the loans according to the standards set by Dodd-Frank. Violation of these requirements could result in legal action or other regulatory action. Additionally, sub-prime borrowers are required to follow advice for home buyers provided by a representative approved by the US Department of Housing and Urban Development (HUD).
Although there are much stricter rules for subprime mortgages today, they are still considered riskier for borrowers and lenders than conventional mortgages.
Types of subprime mortgages
Like conventional mortgages, there are several types of subprime mortgages, including:
- Fixed rate mortgages. With this type of loan, the interest rate is fixed for the term of the mortgage and the payments are the same amount each month. But unlike a conventional mortgage, which typically has a repayment term of 15 or 30 years, subprime fixed-rate mortgages can last 40 to 50 years.
- Adjustable Rate Mortgages (ARM). Rather than an interest rate that remains fixed for the duration of the loan, a subprime ARM offers a low introductory rate that eventually resets based on a market index to which it is linked. For example, with an ARM 5/1, the borrower would pay the introductory rate for the first five years. After that, the rate would be reset one or more times over the remaining 25 years. Usually, lenders cap the rate increase.
- Interest-only mortgages. When you make payments on an interest-only loan, the funds are only used for interest accrued during the first seven to 10 years. Then the payments will be used to repay the principal and interest for the remainder of the term.
- Mortgages of dignity. This type of mortgage is like a hybrid of a subprime mortgage and a conventional mortgage. Borrowers deposit around 10% and agree to pay a higher interest rate for the first few years, usually five. If they make all of their payments on time, the rate is lowered to prime – interest rate banks charge their most creditworthy customers.
Is a subprime mortgage right for me?
Taking out a subprime or non-subprime mortgage is an option when you have poor credit. However, this is not your only one; you may qualify for a government guaranteed mortgage, such as a loan from the Federal Housing Administration (FHA) or the United States Department of Veterans Affairs (VA). These loans offer more flexible credit score and down payment requirements. It is important to consider all of your options before taking out a subprime mortgage.
Also be aware that non-senior home loans are not just for borrowers with bad credit. Certain types of properties are not eligible for conventional loans, such as certain condos or log homes. If you’re self-employed and don’t have a lot of taxable income, you may also be a good candidate for a subprime mortgage. The same goes for foreign nationals in the United States who do not have a credit history.
Benefits and Risks
One of the main advantages of subprime mortgages is that they provide a way to get mortgage financing when you don’t otherwise qualify.
However, just because you qualify for a subprime mortgage doesn’t mean you need to borrow one. While there are some benefits, there are also several risks to consider:
- Higher rates: Subprime mortgage borrowers generally have poor credit scores and other financial problems. This means that it is much riskier for a lender to offer this type of loan than a traditional mortgage. To offset this risk, lenders charge higher interest rates. Currently, the average rate for a conventional 30-year fixed-rate mortgage is less than 3%, but the rate for a subprime mortgage can be as high as 8-10% and require more down payments. important.
- Larger down payment: Another way for some lenders to offset the risk of subprime mortgages is to require higher down payments: up to 25% to 35%, depending on the type of loan. This can be difficult if home values are rising at a rapid rate and you risk getting paid the price of the neighborhood you want. You should also be careful not to put too much of your cash savings in your home. In a financial emergency, you need enough savings to cover your expenses, including your mortgage payment.
- Higher Payments: Since you’ll likely have to pay a higher interest rate on a subprime mortgage, that means you’ll have to pay a higher payment each month. Of course, you shouldn’t borrow more than what you can afford to repay, and lenders will certainly check that out. However, if your financial situation changes, like if you lose your job or experience a medical emergency, these high payments can become too much to handle. Missing mortgage payments can dramatically damage your credit, or worse, trigger a foreclosure.
- Longer terms: With a conventional mortgage, the terms are generally 15 to 30 years. Subprime mortgages, on the other hand, often extend the repayment term to 40 or even 50 years. So you could spend a good chunk of your life on a mortgage payment. But it also means that the amount of interest you pay over the life of the loan increases dramatically.
What is needed to be approved
While subprime mortgages are designed for borrowers with lower credit scores, lenders won’t lend to just anyone. If your credit rating is too low, you will not be eligible for any type of mortgage. Typically, lenders prefer borrowers with a credit score between 580 and 660.
Applying for a subprime mortgage is pretty much the same as a conventional mortgage. You will need to provide lots of documents to show you can handle payments, including a list of your bank accounts and other assets, any debts you currently owe, proof of your income through pay stubs and tax returns. .
What to expect after applying
Once you submit your application and supporting documents, the lender will assess your financial situation and creditworthiness. They will look at your payment history, income and work history, DTI ratio, and other factors. If you are approved, the lender will provide you with a loan estimate that details the terms of the offer and lists any associated fees. You can choose to accept the offer or negotiate different terms.