Subprime Mortgage Loans: Types, Risks, and Government Protections

Subprime mortgage loans can be a complex and risky financial product. They are often given to borrowers with poor credit history, which can lead to higher interest rates and fees.

Subprime mortgage loans can be further divided into three main types: interest-only loans, option adjustable-rate mortgages, and pay-option loans. These types of loans often have features that can make it difficult for borrowers to make payments.

Borrowers who take out subprime mortgage loans may face significant risks, including the possibility of foreclosure. In the past, some lenders have been criticized for targeting vulnerable borrowers with these types of loans.

The government has implemented various protections to help prevent predatory lending practices, including the creation of the Consumer Financial Protection Bureau.

A subprime mortgage loan has a higher interest rate than a regular mortgage loan, because the person taking out the mortgage has a lower credit score and/or a higher debt to income ratio.

Subprime mortgage loans are designed for people with less-than-perfect credit, but they come with higher costs.

Your interest rate will be higher, causing you to pay more in interest over the life of the mortgage loan with bad credit.

Subprime mortgages are now regulated by the Consumer Financial Protection Bureau (CFPB), which was created in response to the subprime crisis.

You'll need to undergo homebuyer counseling with a representative approved by the U.S. Department of Housing and Urban Development (HUD) if you obtain a subprime mortgage.

Higher interest rates and larger down payment requirements are common features of subprime mortgages compared to conventional loans.

Subprime mortgage lenders are more likely to work with you if you have a credit score under 700, and sometimes as low as 580.

A higher interest rate is usually charged on subprime loans because of the higher risk for the investor. The interest rate will depend on how low your credit score is.

To get a lower interest rate, focus on having few late payments in the last 12 months on your credit report. Putting down more money can also boost your chances of being approved.

If you're considering an FHA-backed loan, you may be able to enjoy a competitive interest rate even with a low credit score under 640. However, you'll need to put down at least 10% if your score is below 620.

Here are some common types of subprime mortgage loans:

Keep in mind that the Federal Housing Administration is now guaranteeing loans with as little as 3.5% down, and a credit score as low as 620.

Subprime mortgage lenders offer home loans to people with average to poor credit, often with a 620 credit score or below.

If you have a credit score under 700, you may be able to get a subprime loan from a bad credit mortgage lender, but be prepared for a higher interest rate.

Some subprime lenders will work with you even if your credit score is as low as 580.

Subprime mortgage loans can be FHA-backed, which may offer a lower interest rate than you might think, even with a credit score under 640.

You can still qualify for a competitive interest rate if you put down more money or have had few late payments in the last 12 months on your credit report.

Here are some types of subprime mortgages you can consider:

Keep in mind that subprime mortgages often come with higher interest rates and more onerous down payment requirements, so be sure to carefully review the terms before applying.

Subprime mortgage lenders are offering home loans to people with credit scores as low as 620 or below. This is a significant change from the past.

In recent years, the number of subprime mortgage loans has risen approximately 28% since 2015. This is likely due to the easing of lending criteria.

Today, it's not unusual for subprime mortgage lenders to offer home loans to individuals with average to poor credit. This is because FHA-approved mortgage lenders offer these programs.

FHA will pay back the lender if you don't make your monthly payments. This makes it easier for people with bad credit to secure a mortgage.

Subprime adjustable-rate mortgages, also known as ARMs, are available, where the borrower gets a fixed interest rate for the first three years, then the rate floats for the remaining years.

A subprime fixed-rate mortgage works just like a conventional fixed-rate mortgage, with a set interest rate and the same monthly payment for the entire loan repayment period.

There are also interest-only loans, where the borrower pays only interest during the first few years, typically seven or ten, which can mean smaller monthly payments at first, but no initial payoff of the loan principal, and delayed equity.

Subprime mortgages can come with fixed rates, adjustable rates, or interest-only terms, carrying higher interest rates and often more onerous down payment requirements.

Some subprime mortgage options include:

These options are designed for borrowers with lower credit scores, typically below 600, that prevent them from being approved for conventional loans.

Subprime mortgages are riskier than conventional loans because they're given to borrowers with weakened credit histories and a greater risk of loan default.

Subprime borrowers often have limited or no debt experience, which can make it difficult for lenders to assess their creditworthiness.

Lenders consider various factors when determining risk categories, including the size of the proposed loan and the loan's structure.

Subprime borrowers may have excessive debt, a history of late or missed payments, or even legal judgments against them.

A key consideration for lenders is the originator of the loan, which can sometimes lead to a loan being classified as subprime even if the borrower has "prime" characteristics.

Subprime mortgages have considerably higher interest rates than conventional loans, increasing the borrower's all-in costs.

Here are some characteristics of subprime borrowers:

Government involvement and protections have significantly impacted the subprime mortgage loan industry. Lenders must now underwrite subprime home loans according to Dodd-Frank standards.

The "ability-to-repay" (ATR) provision is a key requirement, ensuring lenders assess whether a borrower can pay back the loan. If a lender violates this rule, they can face lawsuits or regulatory enforcement.

This has led to lenders being more cautious in the non-qualified mortgage space, where they have limited legal protections. As a result, many lenders are hesitant to operate in this space, and the types of subprime loans being made are different from those before the Great Recession.

Lenders must underwrite subprime home loans according to Dodd-Frank standards, which includes the "ability-to-repay" (ATR) provision that requires a thorough assessment of a borrower's ability to pay back the loan.

Violating the ATR rule can result in lawsuits or regulatory enforcement, giving lenders a strong incentive to evaluate borrowers adequately.

Lenders in the non-qualified mortgage space have a strong incentive to follow regulations due to the risk of lawsuits and regulatory enforcement.

The "non-qualified mortgage" designation limits legal protections for lenders, which is a major reason many lenders avoid operating in this space.

Lenders are not making the same kinds of subprime loans as they did before the Great Recession due to regulatory issues.

In the United States, subprime loans are typically classified as those with a FICO score below 600.

The term "subprime" gained popularity during the 2007 subprime mortgage crisis, also known as the credit crunch.

Those loans that don't meet Fannie Mae or Freddie Mac underwriting guidelines for prime mortgages are called "non-conforming" loans.

These non-conforming loans have less secondary market liquidity because they can't be packaged into Fannie Mae or Freddie Mac MBS.

A borrower with a history of making on-time payments will get an A-grade paper loan, while less-than-perfect credit scores may result in A-minus, B-paper, C-paper, or D-paper loans.

Interest payments are progressively increased for less reliable payers to share the risk of default among all borrowers.

Between A-paper and subprime risk is a grade called Alt-A, which is traditionally defined as loans lacking full documentation or with alternative documentation of ability to repay.

The value of U.S. subprime mortgages was estimated at $1.3 trillion as of March 2007, with over 7.5 million first-lien subprime mortgages outstanding.

The subprime mortgage crisis was a result of bundling subprime and regular mortgages into mortgage-backed securities (MBSs) that were traditionally isolated from prime loans. This led to a collapse of confidence in these instruments.

These bundles of mixed mortgages were based on asset-backed securities, making them look like a good investment, but in reality, many subprime mortgages had low initial interest rates that eventually skyrocketed, leaving borrowers with unaffordable payments.

Subprime loans often had adjustable-rate mortgages (ARMs) that started with lower interest rates but could increase by as much as 4% or more per year, making them much more expensive in the long run. For example, a $500,000 loan at 5.5% interest rate for 30 years would have a monthly principal and interest payment of approximately $2,839.43, but the same loan at 8.5% would result in a payment of about $4,079.74.

The lifetime cost of these loans was staggering, with the total cost of the above loan at 5.5% being approximately $1,018,891.24, while the higher rate of 9.5% would incur a lifetime cost of approximately $1,366,390.93.

The subprime mortgage crisis led to a sharp fall in real estate prices, making many of these mortgages almost worthless.

The subprime mortgage crisis was a perfect storm of financial mismanagement and speculation. It was fueled by the bundling of subprime and regular mortgages into mortgage-backed securities (MBSs) that were sold in a separate market from prime loans.

These "bundles" of mixed mortgages were based on asset-backed securities, which made them look like a good investment, but they were actually a ticking time bomb. Many subprime mortgages had low initial interest rates that would adjust significantly after a few years, making them unaffordable for borrowers.

The adjustable-rate mortgages (ARMs) used in many subprime loans were particularly problematic. They came with potential annual adjustments of 4% or more, which could more than double the monthly payment. For example, a $500,000 loan at 5.5% interest rate for 30 years would result in a monthly payment of approximately $2,839.43, but under a typical 3% adjustment cap for 27 years, the payment would increase to about $4,079.74.

The lifetime cost of these loans was staggering, with the total cost of the above loan at 5.5% being approximately $1,018,891.24, and the higher rate of 9.5% incurring a lifetime cost of approximately $1,366,390.93.

The collapse of the housing market led to a sharp decline in property valuations, making many of these mortgages worthless. The "originate-to-distribute" model used by many subprime mortgage originators meant there was little monitoring of credit quality and little effort at remediation when these mortgages became troubled.

The government took several steps to alleviate the crisis, including encouraging lenders to rework payments and terms on troubled mortgages or to refinance "underwater" mortgages.

One of these actions was to reduce repossessions whose subsequent sale could further depress house prices.

Congress passed temporary tax credits for homebuyers, which increased housing demand and eased the fall of house prices in 2009 and 2010.

The maximum size of mortgages that FHA would insure was greatly increased to buttress the funding of mortgages.

FHA loans allow for low down payments, so the agency's share of newly issued mortgages jumped from under 10 percent to over 40 percent.

The Federal Reserve lowered short-term interest rates to nearly 0 percent by early 2009.

The Fed took additional steps to lower longer-term interest rates and stimulate economic activity by buying large quantities of long-term Treasury bonds and mortgage-backed securities.

This included buying securities that funded prime mortgages to further lower interest rates and encourage confidence needed for economic recovery.

The Federal Reserve committed itself to purchasing long-term securities until the job market substantially improved and to keeping short-term interest rates low until unemployment levels declined, so long as inflation remained low.

These moves and other housing policy actions helped stabilize housing markets by 2012.

By 2012, national house prices and home construction began rising, and foreclosure rates resumed falling from recession highs.