If your credit history is preventing you from getting a mortgage, then a subprime, also called non-prime, mortgage may be for you. But are they a good idea?
How Subprime Mortgages work
You take out a subprime mortgage the same way you would take out a conventional mortgage. The biggest difference between the two is the interest rate; because a subprime borrower is at greater risk of default, the lender charges a higher rate. This means in the long run you’ll pay more for your house than you would with a conventional mortgage.
Lenders have their own way of calculating borrower risk. They assign each borrower a grade between A and D. The highes grade is the A-paper and usually mean the borrower has all the following:
- Credit score of 680 or higher
- A debt to income ration lower than 35%
- A 20% down payment
- Documentation of income and assets
Borrowers with an A grade won’t get a subprime mortgage. They’ll qualify for a conventional mortgage with a fixed interest rate that is much lower than a subprime rate.
If you don’t quite qualify for an A grade, you’ll get a lower grade: B, C, or D with D being the lowest. All three are considered subprime and these borrowers usually have the following traits:
- Credit score below 660
- Difficulty paying living expenses
- Debt to income rate higher than 50%
- Bankruptcy in the last 5 years
- Foreclosure in the last 2 years
What are the types of Subprime Mortgages?
- Interest-Only Mortgages – an interest only mortgage requires you to pay only interest for a fixed amount of time, usually between 5 and 10 years. Interest only payments are lower than that of a conventional mortgage…until the interest only time frame ends. Once that time is up, you’ll have to pay both interest and your loan balance. The catch is you don’t get extra time to pay the off your mortgage. So, if you took out a 30-year mortgage with an interest only time period of 10 years, you only have 20 years to pay off the entire loan balance plus interest.
- Dignity Mortgage – These are a new type of subprime mortgage. You pay a higher than normal interest rate, then after five years of paying your mortgage on time, your interest rate is reduced to the standard rate. All the “extra” money that you paid in interest will then go towards your loan balance. From that point on, your interest rate will be the same as a conventional mortgage.
- Negative Amortization Loans – Usually when you pay off a loan, you pay both the interest and a portion of the balance and the amount you owe drops. This is called positive amortization. Negative amortization is the opposite. You can’t pay enough to cover the interest which means every month the loan balance grows. When a lender gives you a negatively amortizing loan, you’ll have a specific time frame in which you’ll pay only a portion of the interest. But eventually they’ll raise your monthly payments and you’ll have to pay all of the interest and a portion of the loan balance
- Balloon Loans – When you take out a balloon loan, you make very small payments for a long time. Small payments, mean you owe more on your loan balance and eventually you will have to make one big payment to repay the entire loan. So let’s say you take out a 5 year balloon loan for a $500,000 house, and every month you pay $2,000 of the loan balance. After 5 years you will have paid $120,000 of your loan which means you will still owe $380,000 which is all due at the end of the 5 year period.
Should You Take Out A Subprime Mortgage?
If you’re still thinking about taking out a subprime mortgage, here are some factors that you should consider:
- Are you really ready to buy a home? – You may think you’re ready, but unless you’re financially ready, you should not take out a mortgage of any kind. If you think you are ready, make sure you’ve covered these basics:
- You’re completely debt free
- You have at least 6 months of expenses saved in an emergency fund
- You’ve saved at least 10% of a down payment
- Your mortgage payment is no more than 25% of your net income
- Do you want to take the extra risk? – If you haven’t paid your debts on time in the past, what make a mortgage debt any different? The lender won’t think twice about taking your home if you begin to miss payments.
- Do you want to pay that much more for a house? – On the surface, it may seem like a subprime mortgage is the way to go, but if you look closer you’ll find that you’re paying significantly more for a home. You’ll be paying a high interest rate, higher closing costs, and paying over a longer term. It’s a great deal for the lender, not so much for you. For example, you buy a $250,000 home on a 30 year subprime mortgage at a 7% interest rate. At the end of your 30 years, you will have paid a total of $774,880. Now lets say you buy a $250,000 home on a 30-year conventional mortgage with a fixed rate of 4.5%. At the end of the term, you will have paid $587,500 for your home; $187,380 less than if you took out a subprime mortgage.