What are the different types of subprime mortgages?

The main types of subprime mortgages include adjustable rate mortgages, fixed-interest mortgages with 40- to 50-year terms and interest-only mortgages.

A mortgage is considered to be subprime if it is given to someone who has poor credit. A poor level of credit is generally defined as a credit score of 640 or less, although it varies. Prime rate mortgages are not offered in these cases because the lender considers the borrower a risk for defaulting on the loan.

Adjustable-Rate Mortgages

An adjustable rate mortgage (ARM) starts out with a flat interest rate and later switches to a floating rate. An example is the 2/28 loan, which is a 30-year mortgage that has a fixed interest rate for two years before being adjusted. Similarly, the 3/27 loan has a fixed interest rate for three years before it becomes variable.

In these cases, the floating rate is determined based on an index plus a margin. A commonly used index is ICE LIBOR. With ARMs, the borrower's monthly payments are usually lower during the initial term and then increase to a higher amount for the remaining term. However, the interest rate may decrease, depending on the index. Also, there is time for the borrower to increase his credit score before the flat-rate period ends, in which case, refinancing may be possible.

Fixed-Interest Mortgages

Another type of subprime mortgage is a fixed-rate mortgage that is given for a 40- or 50-year term, in contrast to the standard 30-year period. This lowers the borrower's monthly payments, but it is more likely to be accompanied by a higher interest rate. That said the interest rates available for fixed-interest mortgages can vary from lender to lender. To research the best interest rates available use a tool like a mortgage calculator.

Interest-Only Mortgages

A third type of subprime mortgage is an interest-only mortgage. For the initial term of the loan, which is typically five, seven or 10 years, payment toward the principal is postponed. This means that the borrower only pays interest. He can choose to make payments toward the principal, but these payments are not required.

When this term ends, the borrower begins paying off the principal, or he can choose to refinance the mortgage. This can be a smart option for a borrower if his income tends to fluctuate from year to year, or if he would like to buy a home and is expecting his income to rise within a few years.

Dignity Mortgages

The dignity mortgage is a new type of subprime loan in which the borrower makes a down payment of about 10% and agrees to pay a higher rate interest for a set period, usually for five years. If he makes the monthly payments on time, after five years, the amount that has been paid toward interest goes toward reducing the balance on the mortgage, and the interest rate is lowered to the prime rate.