Subprime Mortgage

Subprime mortgage loans are loans given to borrowers who fall into the riskiest category of lending. While there is no standard definition as to constitutes a subprime mortgage in the U.S., borrowers with FICO credit scores below 640 are typically considered subprime. Because subprime mortgages are given to those with lower credit scores, they are considered “non-conforming mortgages,” which means that they do not meet the underwriting guidelines laid out by Freddie Mac and Fannie Mae. As such, lenders who originate subprime mortgages will usually need to keep them in their portfolio, rather than selling them on the open market. All of these characteristics of subprime mortgages have important impacts on you, the borrower.

Higher Costs

For the lender, a subprime mortgage loan is a considerably riskier venture than a conventional mortgage. By nature of the lower credit score and poorer credit history of the borrower, the interest rate will immediately be higher. But because subprime mortgages are more difficult to sell on the secondary market - especially after the recent subprime mortgage crisis - lenders themselves must remain exposed to the risk. These higher risks are passed on to the borrower in the form of higher interest rates and fee and lower principals.

Additionally, many subprime borrowers have little savings to use towards a down payment, which means they’ll have to finance a greater percentage of the home. Furthermore, banks may offer to finance the closing costs, which, while reducing the upfront expenses, will increase the amount that is paid over the life of the loan.

Stricter Terms

In order to turn a profit, banks must be highly restrictive in how they manage subprime mortgage loans. As such, many subprime mortgages do not have the same level of flexibility as conventional loans. Subprime mortgages are more likely to have mortgage prepayment penalties, which prohibit borrowers from paying down their mortgage early (either by making extra payments or selling their home) without incurring an additional cost. Many subprime mortgages also have a balloon payment, wherein the full balance of the mortgage is due before the full term is up. For example, if you had a 30 year subprime mortgage loan, it would be amortized for 30 years but the full balance would be due after 10 or 15 years. If this amount wasn’t paid off or refinanced at that time, the home would be foreclosed.

Predatory Lending

Desperation often sends would-be subprime borrowers into the arms of scam artists and predatory lenders. To avoid being ripped off, make sure that you vet each lender carefully. The best way to spot the difference between an ethical lender and a scam artist is to consider how they make a profit. Legitimate banks make money through interest payments and have a vested interest in you making your payments on time and keeping your home. Predatory lenders, on the other hand, make their money through inflated closing costs, which they multiply by pressuring you to refinance over and over. Once you default, they simply foreclose the home and sell it for a profit.

Avoid common predatory lending tactics by speaking with several different banks. Predatory lenders also have a tendency to lie to you about your credit score, so it pays to pull your credit report on your own. Be wary of offers that sound too good to be true, such as no down payment loans, no cost refinancing and interest only mortgages. While these are legitimate mortgage instruments, when it comes to subprime mortgages, these are not usually prudent choices for the borrower.