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A subprime mortgage is a type of loan granted to individuals with poor credit scores (640 or less, and often below 600), who, as a result of their deficient credit histories, would not be able to qualify for conventional mortgages. Because subprime borrowers present a higher risk for lenders, subprime mortgages usually charge interest rates above the prime lending rate.

Why Subprime Mortgages are Risky

A large amount of risk is associated with subprime mortgages. Since the mortgages are specifically for people who do not fit the requirements for a prime-rate mortgage (which usually means the borrower will have a difficult time paying the loan back), the organization or bank lending the money has the right to charge high interest rates to provide an added incentive for the borrower to pay on time. But when people who may already have had trouble handling debt in the past take out these loans, they face a more difficult (and expensive) future than those who have good credit scores and can afford loans with more reasonable interest rates.

 There are several different kinds of subprime mortgage structures available.

Types of Subprime Mortgages

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

Fixed-Interest Mortgages

Another type of subprime mortgage is a fixed-rate mortgage, 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 substantially 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; 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.

Adjustable-Rate Mortgages

An adjustable rate mortgage (ARM) starts out with a fixed-interest rate and later switches to a floating rate. One common example is the 2/28 ARM, which is a 30-year mortgage that has a fixed interest rate for two years before being adjusted. Another typical loan, the 3/27 ARM, 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; when their mortgages reset to the higher, variable rate, mortgage payments usually increase significantly. Of course, the interest rate could decrease over time, depending on the index and economic conditions, which in turn shrinks the payment amount.

But in the short term, it's usually a big bump up. This is one of the factors that lead to the sharp increase in the number of subprime mortgage foreclosures in August of 2006, and the bursting of housing bubble that ensued the following year.

The Subprime Mortgage Meltdown

Subprime mortgages and the subprime meltdown are usually the culprits named for the onset of The Great Recession.

Many lenders were liberal in granting these loans from 2004 to 2006, as a result of lower interest rates, high capital liquidity – and the chance to make a lot of profit. In extending these higher-risk loans, lenders charged interest rates above prime in order to compensate for the additional risk they assumed. They also funded the mortgages by pooling them and then selling them to investors. The heavy increase in people who could suddenly afford mortgages led to a housing shortage, which raised housing prices – and thus the amount of financing would-be homeowners needed.

It seemed like an ever-upward spiral. The downside was that loans were being given out to people who could not pay them back. When huge numbers of them began defaulting on their mortgages, and the rate of housing foreclosures skyrocketed, the lenders lost all of the money they had extended, and then some. So did many financial institutions that had invested heavily in the securitized packaged mortgages. Many experienced extreme financial difficulties, and even bankruptcy.

The subprime mortgage crisis continued from 2007-2010, morphing into a global recession as its effects radiated throughout financial markets and economies around the world. (To learn more, read "The Fuel That Fed The Subprime Meltdown.")

Subprime Mortgages Today

After the housing bubble burst, it was virtually impossible for someone with a credit score below 640 to obtain a home loan. Now that the economy is beginning to stabilize, subprime mortgages are making a comeback. Even Wells Fargo has gotten in on the new subprime bandwagon. Wells Fargo is now approving potential home buyers with credit scores as low as 600 for Federal Housing Administration (FHA) loans.

This time around, though, the Consumer Financial Protection Bureau (CFPB) places restrictions on these subprime mortgages. Potential homebuyers must be given homebuyer's counseling by a representative that has been approved by the U.S. Department of Housing and Urban Development. Other restrictions placed on these new subprime mortgages limit interest rate increases and other terms of the loan.

They are also coming back at an increased cost. Now, subprime mortgages come with interest rates that can be as high as 8% to 10% and may require down payments of as much as 25% to 35%.

The Bottom Line

Although subprime lending increases the number of people who can buy homes, it makes it more difficult for those people to do so and increases the chances that they will default on their loans. Defaulting hurts both the borrower (in terms of credit score) and the lender (which does not get its money back).

Defenders of the new subprime mortgages point out that homebuyers are not forced to pay those high percentage interest rates indefinitely. Once the buyers can prove that they are capable of paying their mortgages on time, their credit scores should increase, and they can refinance their home loans at lower rates. Indeed, many people who take out ARMs are betting on the fact that by the time the variable rate kicks in, they will have cleaned up their credit report to the extent they will qualify for new, more advantageous financing.

For more information, read "Subprime Lending: Helping Hand Or Underhanded?"

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