Bad Credit Series: What to Expect with a Subprime Mortgage

Home ownership is a dream a lot of people share. But for some, meeting the expectations for lenders can be a challenge. Maybe you can afford a rent payment, but saving up for a down payment is a struggle. Or maybe you’ve got the down payment, but there are blemishes on your credit that are preventing you from qualifying for a conventional mortgage. Whatever the situation, a traditional mortgage isn’t in your grasp, but a subprime mortgage is. Before getting excited and signing all the documents, you’ll want to consider exactly what you’re signing up for with bad credit home loans and if it’s worth it in the end.

What Is a Subprime Mortgage?

A subprime mortgage is exactly what it sounds like, a mortgage with less favorable terms than a mainstream mortgage. Conventional loans have interest rates that are lower for those with good and excellent credit. If your credit score is blemished, then you won’t see such favorable interest rates.

For example, if the prime rate (the rate at which banks loan to their best commercial customers) is 3%, your interest rate because of your lower credit score might be 4.25%. The additional 1.25% might not seem like a lot, but look at it this way: If you got a loan for $100 and had to pay back the initial $100 plus interest, at 3%, you would pay back $103, and at 4.25% you’d pay back $104.25.

That still might not seem like a lot, but when the $100 is actually $100,000 and the payment isn’t just once but once a month for years, you can see how that extra 1.25% can start to add up.

Examples of subprime mortgages can include:

• Subprime adjustable-rate mortgages: you start out with a lower loan payment, but after a period of time, the payment is adjusted to a higher amount because the interest rate goes up.

• Interest-only mortgages: you pay only the interest portion of the loan for a period of time, and after that time expires, you pay both the interest and the principal.

• Extended-term mortgages: instead of having a mortgage for the traditional term of 15-30 years, the mortgage is extended to 40-50 years.

You’ll Probably Pay a Higher Interest Rate

We talked about this previously, but it cannot be stressed enough, regardless of the type of subprime mortgage you end up with, you’re going to pay a higher interest rate. In some cases, the higher rate starts with the first payment, while in other cases you get a few years of a low rate followed by years of higher rates. For example, if you are approved for what is called a dignity mortgage, you’ll start out with a high interest rate, but generally after five years of on-time payments, the rate drops down to prime rate levels.

On the other hand, if you go for an adjustable-rate mortgage (ARM), which can remain at a fixed rate for up to 10 years, but is subjected to changing interest rates after this fixed-rate period, causing the payment to adjust. The adjustment is based on the current rate plus a margin. Often, this results in a rise in interest, but not always.

Changing Terms

Subprime loans may change at some point during the loan. Take the subprime ARM example above. After a set number of years, your mortgage payment will increase because the interest rate has adjusted. The mortgage payment will also change with the dignity mortgage, though that change in the interest rate is most likely for the better and can result in a lower mortgage payment. The point is, unlike fixed-rate mortgages, where your first payment is the same as your last payment 20 years later, your payment with one of many of the adjustable-rate subprime mortgages is going to change.

Sticker Shock

Subprime loans have higher interest rates (we’ve mentioned this a few times), but in the case of adjustable rate mortgages and other loans, the amount the monthly payment changes can be dramatic. The same shock can happen with an interest-only loan when you go from paying only the interest to paying the principal plus interest. It is this increase that often turns what was a perfectly doable loan into a home buyer’s nightmare.

Real Possibility of Default

Now, some people who qualify for subprime loans but not conventional mortgages can run the gamut from a young person with no or very little credit to a couple who made some financial missteps with credit cards or a car loan and are in the process of rebuilding their credit. Regardless of the reason, these people qualify for loans that can become a nightmare if the borrower isn’t aware and prepared to follow the guidelines to the letter. Subprime loans have a higher default rate than conventional loans mainly because the payments can quickly spiral from affordable to prohibitive. And if you thought bouncing back from a credit card charge-off and an auto repossession was tough, that’s nothing compared to the hit you’ll take on a foreclosure.

How to Play the System

So after all this talk of how bad subprime loans are and how dangerous it is to take one out, you most likely think we’re completely against them. Well, you’d be wrong. Although these loans aren’t for everyone and there have been entirely too many cases of people getting these loans and being ill-equipped to carry through with the agreement, there are times when these loans are ideal.

For example, if you’re in medical school or law school and are poised to graduate and earn a high salary, getting a mortgage with a subprime rate either up front or after a few years is acceptable, since you’ll have the income to support the higher payment and will likely be in a better financial position to refinance. Or if you know you plan to sell the home after a few years, taking out an ARM and selling before the rate adjustment kicks in makes sense.

The key is knowing what you’re dealing with and having a game plan to handle it. If you can pull that off, then a subprime mortgage can work to your advantage.