These loans are often adjustable-rate mortgages (ARM) and come with an initial low interest rate. The initial rate can make the payments manageable in the beginning, but it will expire after a fixed period of time. Once the initial rate expires, the interest rate will adjust based on current market conditions. This can result in payment shock for the borrower, and can lead to delinquencies in payment or even eventual foreclosure.
How a Subprime Mortgage Works
The terms “prime” and “subprime” refer to the interest rate given based on a borrower’s credit history. A prime mortgage comes with the lowest rates, and is reserved for borrowers with excellent credit. In comparison, a subprime borrower has a poor credit history and will qualify for loans with higher interest rates and less-favorable terms. Here are some factors that could cause a borrower to be considered subprime:
A credit score below 620A history of payment delinquencies on your credit reportYou’ve filed for bankruptcy in the last five years.A high debt-to-income ratioYou’ve had property repossessed or faced a foreclosure.
Types of Subprime Mortgages
Here are some of the most common types of subprime mortgages you’ll encounter.
Interest-Only Mortgage
An interest-only mortgage is a loan that only requires you to make interest payments for a set period of time. This means you’ll have low payments in the beginning, but they can rise substantially once the initial period is over. Many people take out interest-only mortgages with plans to refinance before their payment increases. But if your property value decreases or your financial situation changes, you may find yourself unable to refinance.
Adjustable-Rate Mortgage (ARM)
Unlike a fixed-rate mortgage, an ARM comes with interest rates that will periodically change over the life of the loan. You’ll start with a low introductory rate, then the interest rate will adjust depending on current market conditions. Before applying for an ARM, it’s important to ensure you can afford the mortgage payments at a higher interest rate. Determine the interest-rate cap to figure out whether you can afford higher mortgage payments.
Balloon Payments
If you take out a mortgage with a balloon payment, you’ll have a large, one-time payment at the end of your loan. Your payments will be lower in the years leading up to the balloon payment, but your final payment could be tens of thousands of dollars. Before taking out this type of loan, make sure you can afford the balloon payment once it’s due. Again, don’t just assume you can refinance first, because this could put you in a bad spot financially.
Notable Happenings
The 2008 financial crash was largely attributed to a high number of defaults on subprime mortgages. Subprime borrowers could qualify for mortgages without having to provide proof of income or down payments. Lenders sometimes relied on stated income—a borrower could claim to earn a six-figure income but didn’t have to provide any documentation. This meant many borrowers qualified for mortgages they couldn’t afford. When the housing market crashed, these borrowers found themselves underwater on their houses. The house was worth less than what they owed on the mortgage, and they were unable to afford the mortgage payments at the higher interest rates. Want to read more content like this? Sign up for The Balance’s newsletter for daily insights, analysis, and financial tips, all delivered straight to your inbox every morning!
