The Risk of Subprime Mortgages by a New Name

The mere mention of the word "subprime" is enough to send chills down the backs of investors, bankers, and homeowners. And there's a very good reason why. 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.

There are several different kinds of subprime mortgage structures available on the market. But does a rose by any other name smell as sweet? That may not necessarily be the case. Read on to find out more about these mortgages and what they represent.

What Is a Subprime Mortgage?

A subprime mortgage is a type of loan granted to individuals with poor credit scores—620 or less, and often below 600—who, as a result of their deficient credit histories, would not be able to qualify for conventional mortgages.

There's a large amount of risk associated with any subprime mortgage. The term subprime itself refers to the borrowers and their financial situation rather than the loan itself. Subprime borrowers are more likely to default than those who have higher credit scores.

Because subprime borrowers present a higher risk for lenders, subprime mortgages usually charge interest rates above the prime lending rate. Subprime mortgage interest rates are determined by several different factors: Down payment, credit score, late payments, and delinquencies on a borrower's credit report.

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 lengthy loan period lowers the borrower's monthly payments, but it is more likely to be accompanied by a higher interest rate. 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.

Adjustable-Rate Mortgages

An adjustable-rate mortgage starts out with a fixed interest rate and later, during the life of the loan, switches to a floating rate. One common example is the 2/28 ARM. The 2/28 ARM is a 30-year mortgage with a fixed interest rate for two years before being adjusted. Another typical version of the ARM loan, the 3/27 ARM, has a fixed interest rate for three years before it becomes variable.

In these types of loans, the floating rate is determined based on an index plus a margin. A commonly used index is the SOFR (secured overnight financing rate). With ARMs, the borrower's monthly payments are usually lower during the initial term. However, 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, would shrink the payment amount.

ARMs played a huge role in the crisis. When home prices started to drop, many homeowners understood that their homes weren't worth the amount the purchase price. This, coupled with the rise in interest rates led to a massive amount of default. This led to a drastic increase in the number of subprime mortgage foreclosures in August of 2006 and the bursting of the housing bubble that ensued the following year.

Interest-Only Mortgages

The 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, principal payments are postponed so 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.

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. With the economy stabilizing, subprime mortgages are making a comeback. Demand from homeowners and lenders is increasing for these kinds of home loans. Wells Fargo also took a position in the new subprime bandwagon. Until 2015, the bank was 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 counseling by a representative who is 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. All loans must also be properly underwritten.

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%.

Subprime Mortgages Are Risky

Since these mortgages are specifically for people who do not qualify 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, not to mention expensive future than those who have good credit scores and can afford loans with more reasonable interest rates.

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. By 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 as repackaged investments. 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 began to default on their mortgages and the rate of housing foreclosures skyrocketed, the lenders lost all of the money they extended. So did many financial institutions that invested heavily in the securitized packaged mortgages. Many experienced extreme financial difficulties—even bankruptcy.

The subprime mortgage crisis continued from 2007 to 2010, morphing into a global recession as its effects radiated throughout financial markets and economies around the world.

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 and his credit score as well as the lender.

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.