What is the definition of a subprime loan?
Editorial Note: We earn a commission from partner links on Forbes Advisor. Commissions do not affect our editors' opinions or evaluations. Show
If you dream of becoming a homeowner, but bad credit is getting in the way of making it a reality, a subprime mortgage might be a better option. While these loans are designed for higher-risk borrowers, they do come with some risks of their own. Here’s what you should know before considering a subprime mortgage. Who Are Subprime Mortgage Borrowers?Mortgage applicants with poor credit scores and negative items on their credit reports are often considered subprime. Whereas, prime borrowers have good credit and a strong financial track record, so the lender is 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, that’s defined as a borrower with a credit score of 660 or less. According to the Federal Deposit Insurance Corp (FDIC), a subprime borrower is also someone who:
Home loans designed for these types of higher-risk borrowers are considered subprime or nonprime mortgages. The term subprime may sound familiar thanks to the subprime mortgage crisis. Prior to 2008, mortgage lenders had much looser standards for approving borrowers with poor credit scores and financial track records. These were also sometimes called no-doc loans because some lenders were not requiring documented proof of income. Eventually, many of those borrowers defaulted on their loans. Between 2007 and 2010, foreclosures skyrocketed and banks lost tons of money, causing the government to bail out many big banks, while others merged or were sold through failure. In response to the subprime mortgage crisis, the Dodd-Frank Act of 2010 was established to overhaul financial regulation in order to prevent a similar crisis in the future. Included in the act is a lender requirement called the ability-to-repay (ATR) rule. This rule requires mortgage lenders to establish a thorough process for evaluating whether a borrower is able to repay the loan according to its terms, pretty much ending the practice of no-doc mortgage loans. Lenders also have to underwrite loans according to the standards outlined by Dodd-Frank. Violating these requirements could result in a lawsuit or other regulatory action. Additionally, subprime borrowers are required to attend homebuyer counseling provided by a representative approved by the U.S. Department of Housing and Urban Development (HUD). Though there are much stricter rules surrounding subprime mortgages today, they are still considered more risky for borrowers and lenders over conventional mortgage loans. Types of Subprime MortgagesLike conventional mortgages, there are several types of subprime mortgages, including:
Is a Subprime Mortgage Right for Me?Taking out a subprime or nonprime mortgage is one option when you have poor credit. However, it’s not your only one; you may qualify for a government-backed mortgage such as an 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’s important to consider all your options before pursuing a subprime mortgage. Also know that nonprime home loans aren’t just for borrowers with bad credit. Some types of properties don’t qualify for conventional loans, such as certain condos or log homes. If you’re self-employed and don’t have much taxable income, you may also be a good candidate for a subprime mortgage. The same is true of foreign nationals in the U.S. who don’t have a credit history. Benefits and RisksOne of the biggest benefits to subprime mortgages is that they provide an avenue for securing home financing when you don’t qualify otherwise. However, just because you qualify for a subprime mortgage doesn’t mean you should borrow one. Though there are some benefits, there are also several risks to consider:
What’s Needed to Get ApprovedThough subprime mortgages are designed for borrowers with lower credit scores, lenders won’t lend to just anyone. If your credit score is too low, you won’t be able to qualify for any type of mortgage. Generally, lenders prefer borrowers with credit scores in the range of 580 to 660. Applying for a subprime mortgage is pretty much the same as a conventional mortgage. You’ll need to provide plenty of documentation to show you can handle the payments, including a list of your bank accounts and other assets, any debts you currently owe, proof of your income via paystubs and tax returns. What to Expect After You ApplyOnce you submit your application and supporting documents, the lender will evaluate your financial situation and creditworthiness. They’ll look at your payment history, income and job history, DTI ratio and other factors. If you’re approved, the lender will provide you with a loan estimate that details the terms of the offer and lists out all associated fees. You can choose to accept the offer or negotiate different terms. What is considered a subprime loan?Subprime (credit scores of 580-619) Near-prime (credit scores of 620-659) Prime (credit scores of 660-719)
How is subprime defined?“Subprime” refers to the below-average credit score of the individual taking out the mortgage, indicating that they might be a credit risk. The interest rate associated with a subprime mortgage is usually high to compensate lenders for taking the risk that the borrower will default on the loan.
What is another name for subprime loans?Subprime mortgage were one of the main drivers that led to the Great Recession. But they seem to be making a comeback with a new name—nonprime mortgages.
What is the difference between a prime and subprime borrower?What Does It Mean to Be a Prime or Subprime Borrower? Prime borrowers are considered the least likely to default on a loan. Subprime borrowers, meanwhile, are viewed as higher default risks due to having limited or damaged credit histories. Lenders use several FICO® Score ranges to categorize loan applicants.
|