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If you dream of becoming a homeowner but bad credit stands in the way, a subprime mortgage might be a better option. Although these loans are designed for higher risk borrowers, they come with some risks of their own.
Here’s what you should know before considering a subprime mortgage.
Who Are Subprime Mortgage Borrowers?
Mortgage applicant with bad credit and negative items in their credit reports are often viewed as subprime. While top notch borrowers Good credit and a strong financial track record, making the lender more likely to offer them a loan at a lower interest rate.
Today, financial institutions often use the term nonprime instead of subprime, but the meaning is the same. Generally speaking, this is a borrower with a credit score of 660 or less. According to the Federal Deposit Insurance Corp. (FDIC) is a subprime borrower also someone who:
- Had at least two payments 30 days late in the last 12 months or at least one payment 60 days late in the last 24 months
- Have experienced a judgment, foreclosure, repossession, or charge in the past 24 months
- Filed for bankruptcy in the past five years
- Has a Debt-Income Ratio (DTI) of at least 50%
Home loans for this type of higher risk borrower are considered subprime or nonprime mortgages.
The term subprime may sound familiar due to the subprime mortgage crisis. Before 2008, mortgage lenders had much looser standards for approving borrowers with poor credit scores and financial track records. These were sometimes referred to as no-doc loans because some lenders did not require documented proof of income.
After all, many of these borrowers have defaulted on their loans. Between 2007 and 2010 foreclosures skyrocketed and banks lost massive amounts of money, leading the government to bail out many large banks while others merged or were sold through bankruptcy.
In response to the sub-prime mortgage crisis, the 2010 Dodd-Frank Act was enacted to revise financial regulation to prevent a similar crisis from occurring in the future. The law includes a lender requirement called the Repayment Eligibility Rule (ATR). This rule requires that mortgage lenders put in place a thorough process of evaluating whether a borrower will be able to repay the loan according to their terms, which virtually ends the practice of no-doc mortgage loans.
Lenders are also required to draw up loans according to the standards set by Dodd-Frank. Failure to comply with these requirements could result in a lawsuit or other regulatory action. In addition, subprime borrowers are required to obtain homebuyer advice from a US Department of Housing and Urban Development (HUD) approved agent.
Although there are much stricter rules on subprime mortgages today, they are still considered riskier than traditional mortgage loans for borrowers and lenders.
Types of Subprime Mortgages
As with traditional mortgages, there are several types of sub-prime mortgages, including:
- Fixed Rate Mortgages. With this type of loan, the interest rate is fixed for the duration of the mortgage and payments are made every month at the same rate. However, unlike a traditional mortgage, which typically has a 15 or 30 year term, subprime fixed rate mortgages can last for 40 to 50 years.
- Adjustable Rate Mortgages (ARM). Instead of an interest rate that remains fixed for the entire duration of the loan, a subprime ARM offers a low introductory price that will eventually reset according to a market index to which it is tied. For example, with a 5/1 ARM, the borrower would pay the introductory interest rate for the first five years. Thereafter, the interest rate would be reset one or more times in the remaining 25 years. Usually, lenders limit how much the rate can be increased.
- Interest-bearing mortgages only. When paying on a interest-free loan, the funds are only used for the accrued interest of the first seven to ten years. Then payments are used to repay principal and interest for the remainder of the term.
- Would mortgage. This type of mortgage is like a mix of a sub-prime and a conventional mortgage. Borrowers put about 10% off and commit to paying a higher interest rate for the first few years – usually five. If they make all payments on time, the interest rate will be lowered to the base rate – the interest banks charge their most creditworthy customers.
Is A Subprime Mortgage Right For Me?
Taking out a subprime or nonprime mortgage is an option if you have poor credit. It is not your only one, however; You can qualify for a government-secured mortgage, such as: Federal Housing Administration (FHA) or U.S. Department of Veterans Affairs (VA) loan. These loans offer more relaxed credit score and down payment requirements. It is important to weigh all of your options before deciding on a subprime mortgage.
Also note that non-prime home loans are not only intended for borrowers with poor credit ratings. Some types of real estate do not qualify for conventional loans, such as: B. certain condominiums or log cabins. If you are self-employed and don’t have much taxable income, you might also be a good candidate for a subprime mortgage. The same goes for foreigners in the US who have no credit history.
Benefits and Risks
One of the greatest advantages of subprime mortgages is that they provide a way to secure home financing if you don’t otherwise qualify.
However, just because you qualify for a subprime mortgage doesn’t mean you should borrow one. While there are some benefits, there are also some risks to consider:
- Higher rates: Subprime mortgage borrowers generally have poor credit ratings and other financial challenges. 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. Right now, the average interest rate on a 30 year conventional fixed rate mortgage is less than 3%, but the interest rate on a subprime mortgage can be between 8% and 10% and require higher down payments.
- Larger deposit: Another way to offset the risk of subprime mortgages is to have some lenders charge higher down payments: up to 25% to 35%, depending on the type of loan. This can be tricky when property values are rising rapidly and you risk being challenged from your desired neighborhood. You also need to be careful not to put too much of your cash savings into your home. In the event of a financial emergency, you will need enough savings to cover expenses, including paying the mortgage.
- Higher payments: Since you will likely have to pay a higher interest rate on a subprime mortgage, it means that you will be charged a higher payment each month. Obviously, you shouldn’t borrow more than you can afford and lenders will surely check it out. However, if your financial situation changes – such as losing your job or experiencing a medical emergency – these high payments can become too much. Missing mortgage payments can seriously damage your creditworthiness or, worse, trigger foreclosure.
- Longer terms: With a conventional mortgage, the terms are usually 15 to 30 years. Subprime mortgages, on the other hand, often extend the term to 40 or even 50 years. So you could be spending a good part of your life paying off a mortgage. But this also means that the amount of interest you pay over the term of the loan increases dramatically.
What is required to get approved
Although subprime mortgages are designed for borrowers with lower credit scores, lenders don’t give out to anyone. If your credit score is too low, you may not qualify for any type of mortgage. In general, lenders prefer borrowers with credit ratings in the 580 to 660 range.
Applying for a subprime mortgage is similar to applying for a traditional mortgage. You’ll need to provide numerous documents showing that you can handle the payments, including a list of your bank accounts and other assets, any debts you currently owe, proof of income on payroll, and tax returns.
What to expect after applying
Once you have submitted your application and supporting documents, the lender will assess your financial situation and creditworthiness. They will look at your payment history, income and job history, DTI rate and other factors. If you are approved, the lender will provide you with one Credit estimate detailing the terms of the offer and any associated fees. You can accept the offer or negotiate other terms.