How Subprime Mortgages Work

There has been a lot of talk in the current housing market about subprime mortgages. Those new to the real estate process may have heard about subprime mortgages, but may not really be sure how they work.

What Is a Subprime Mortgage?

A subprime mortgage loan is offered to a less than prime borrower. Lending agencies look at credit scores to assess risk. The lower the credit score, the more likely a person is to default on his or her mortgage loan.

Credit scores in the U.S. range from 300-900. Someone with a credit score below 620 is considered a high-risk borrower. This makes him or her a less attractive candidate for a loan from the lender’s point of view. A subprime mortgage allows the lender to offer a mortgage to these borrowers. These mortgage loans come with higher fees and interest rates to offset the greater risk of default.

What Are the Problems With Subprime Mortgages?

There is no problem with the idea of subprime mortgages. The problem lies in the predatory lending practices of some lenders. Loan agencies that offer mortgages to subprime borrowers are still supposed to be responsible in working out terms that the borrower can afford. In recent years, this has not been the case.

Some lenders have even offered “no check” loans at exorbitant fees in which there is virtually no check on the financial background of the borrower. This is a highly inappropriate lending practice and quickly leads to high fees for a desperate borrower. Other subprime lenders have offered introductory teaser rates that balloon into high rates the borrower cannot pay once the loan payments have begun.

The reason the crisis has become so widespread is that in addition to the massive foreclosures resulting from bad subprime lending practices, investors have also suffered. Some mortgage lenders bundle their subprime loans into securities that people can invest in. The high level of defaults has devastated anyone invested in these securities.

Should You Get a Subprime Mortgage?

If you can afford a traditional mortgage loan, you should get that instead, even if it means borrowing slightly less money than you would have hoped. If you cannot, a subprime mortgage is still an option if you can get one.

However, you need to approach your subprime mortgage with eyes wide open. Have a plan for making the payments from start to finish and don't be fooled by easy introductory terms or harmless seeming balloon payments down the road.