What Is a Subprime Mortgage? Credit Scores, Interest Rates

What Is a Subprime Mortgage?

A subprime mortgage is one that’s normally issued to borrowers with low credit ratings. A prime conventional mortgage isn’t offered, because the lender views the borrower as having a greater-than-average risk of defaulting on the loan.

Lending institutions often charge interest on subprime mortgages at a much higher rate than on prime mortgages to compensate for carrying more risk. These are often adjustable-rate mortgages (ARMs) as well, so the interest rate can potentially increase at specified points in time.

Key Takeaways

“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.
These borrowers typically have credit scores below 620 along with other negative information in their credit reports.
The 2008 financial crisis has been blamed in large part on the proliferation of subprime mortgages offered to unqualified buyers in the years leading up to the meltdown.
New mortgages to subprime borrowers have restrictions placed on them and must be properly underwritten.

Subprime Mortgage: A mortgage issued to borrowers with low credit ratings. — Investopedia / Theresa Chiechi

Understanding Subprime Mortgages

“Subprime” doesn’t refer to the interest rates often attached to these mortgages, but rather the credit score of the individual taking out the mortgage. Borrowers with FICO credit scores below 620 will often be stuck with subprime mortgages and their corresponding higher interest rates.

It can be useful for people with low credit scores to wait for a period of time and build up their credit histories before applying for a mortgage, so they might qualify for a prime loan.

The interest rate associated with a subprime mortgage is dependent on four factors: credit score, the size of the down payment, the number of late payment delinquencies on a borrower’s credit report, and the types of delinquencies found on the report. A mortgage calculator is a good resource to see how different interest rates would affect a monthly payment.

Different lenders will use different rules for what constitutes a subprime loan, but FICO scores below 640, 620, or 600 have typically been classified as subprime cut-offs in the past. The Consumer Financial Protection Bureau classifies credit scores between 619 and 580 as subprime.

Subprime Mortgages vs. Prime Mortgages

Mortgage applicants are typically graded from A to F, with A scores going to those with exemplary credit, and F scores going to those with no discernible ability to repay a loan at all. Prime mortgages go to A and B candidates, whereas lower-rated candidates must typically resign themselves to subprime loans if they’re going to get loans at all.

Lenders aren’t legally obligated to offer you the best available mortgage terms or even let you know that they’re available, so consider applying for a prime mortgage first to find out if you do indeed qualify.

Role in the 2008 Housing Market Crash

The 2008 housing market crash was due in large part to widespread defaults on subprime mortgages. Many borrowers were given what were known as NINJA loans, an acronym derived from the phrase “no income, no job, and no assets.”

These mortgages were often issued with no down payment required, and proof of income was not necessary either. A buyer might state earnings of $150,000 a year but did not have to provide documentation to substantiate the claim.

These borrowers then found themselves underwater in a declining housing market, with their home values lower than the mortgage they owed. Many of these NINJA borrowers defaulted because the interest rates associated with the loans were “teaser rates,” variable rates that started low and ballooned over time, making it very hard to pay down the principal of the mortgage.

Even after the financial crash, subprime mortgages didn't go away. Wells Fargo began offering mortgages to individuals with credit ratings in the low 600s again in 2014. The nonprofit, community advocacy, and homeownership organization Neighborhood Assistance Corporation of America continued its Achieve the Dream tour in 2018, hosting events nationwide to help people apply for “non-prime” loans, which are effectively the same as subprime mortgages.

COVID-19 Mortgage Relief

The Coronavirus Aid, Relief, and Economic Security (CARES) Act, signed into law on March 27, 2020, provided some temporary relief to those who found themselves unable to make their mortgage payments due to the initial financial fallout from the coronavirus pandemic.

If backed by the federal government or an agency like Freddie Mac or Fannie Mae, mortgage lenders or loan servicers were not allowed to foreclose on homeowners until July 31, 2021. Additionally, those who experienced financial hardship due to the pandemic were able to request and obtain a loan forbearance for up to 180 days without penalty.

The American Rescue Plan (ARP) Act of 2021 signed by President Biden also provided additional support. The nearly $2 trillion coronavirus rescue package contained additional funding which provided relief to those behind on mortgages, rent, and utility bills. The legislation issued:

$21.55 billion for emergency rental assistance through Sept. 30, 2027
$5 billion in emergency housing vouchers through Sept. 30, 2030
$750 million for tribal housing
$100 million for rural housing
$5 billion to assist people experiencing homelessness

Homeowners in need of assistance with mortgage payments should consult the National Low Income Housing Coalition's website, which provides a searchable list of all the programs currently available.

What Does a Subprime Loan Mean?

A subprime loan is a type of loan offered at a rate above prime to individuals who do not qualify for prime-rate loans. Quite often, subprime borrowers have been turned down by traditional lenders because of their low credit ratings or other factors that suggest they have a reasonable chance of defaulting on the debt repayment.

What Is the Difference Between a Prime Loan and a Subprime Loan?

Because subprime borrowers are riskier, they carry higher interest rates than prime loans. The specific amount of interest charged on a subprime loan is not set in stone. Different lenders may not evaluate a borrower’s risk in the same manner. This means a subprime loan borrower has an opportunity to save some money by shopping around. Still, by definition, all subprime loan rates are higher than the prime rate.

Who Offers Subprime Mortgages?

While any financial institution could offer a loan with subprime rates, there are lenders that focus on subprime loans with high rates. Arguably, these lenders give borrowers who have trouble getting low-interest rates the ability to access capital to invest, grow their businesses, or buy homes. At the same time, the higher interest rates on subprime loans can translate into tens of thousands of dollars in additional interest payments over the life of a loan.

What Are the Drawbacks of Subprime Loans?

For borrowers, the higher interest rates will mean a costlier loan over time, which may be harder to service for a borrower who already has financial troubles. On a systemic level, defaults on subprime loans have been identified as a key factor in the 2008-09 financial crisis.

Lenders are often seen as the biggest culprits, freely granting loans to people who couldn't afford them because of free-flowing capital following the dot-com bubble of the early 2000s. Still, borrowers that bought homes they truly could not afford contributed as well.

Did Subprime Lending Cause the 2008-09 Financial Crisis?

Most experts agree that subprime mortgages were an important part of the financial crisis. When it comes to the subprime mortgage part of the crisis, there was no single entity or individual at whom one could point the finger. Instead, this crisis involved the interplay between the world's central banks, homeowners, lenders, credit rating agencies, underwriters, and investors.

The Bottom Line

Subprime mortgages are mortgages offered to borrowers with low credit ratings. Subprime mortgages are viewed as a greater risk to the lender and, therefore, come with higher interest rates. Depending on the personal situation of the borrower, it may be beneficial to wait till their credit score improves before taking out a mortgage so that they may obtain better interest rates.