What Is a Subprime Mortgage and Why Is It Risky?

A subprime mortgage, also called a non-prime mortgage, is a high-rate mortgage loan for borrowers who don’t qualify for prevailing market interest rates. Unlike prime borrowers, who are at low risk of defaulting on their mortgage loan, subprime borrowers’ low income and/or poor credit make them a risky bet for lenders. Lenders charge subprime borrowers high interest rates to compensate for some of that risk.

Subprime mortgage loans put homeownership within reach of qualified borrowers who’d otherwise not be able to get financing. However, the high rates mean they get less house for more money compared to prime borrowers.

What is a subprime mortgage?

A subprime mortgage is a high-interest loan lenders offer to borrowers whose low income or bad credit pose a “credit risk” — that is, puts them at heightened risk of defaulting on their mortgage loan. Some of the characteristics that make a borrower “subprime” are:

• A credit score below 620
• A recent bankruptcy, judgment, foreclosure, or other action
• Delinquent payments on credit accounts
• High debt-to-income ratio (DTI)

Subprime loans became prevalent during the early and mid-2000s, when mortgage lenders began offsetting the risk of lending to less-qualified borrowers by repackaging, or grouping a pool of such loans together and selling them to investors. The process is called securitization, and it eventually resulted in the housing and mortgage market crash of 2007.

Subprime mortgages vs. prime mortgages

The primary differences between subprime and prime mortgages are interest rates and the eligibility criteria.

How do subprime mortgages work?

Subprime mortgages work in essentially the same way as prime mortgages, but lenders use different criteria to determine whether a borrower is eligible for the loan. If they are, they’ll pay more for it than they would for a prime loan. The higher interest offsets the risk lenders accept when they approve a loan for a less-qualified borrower.

It was that process for reducing risks associated with subprime loans that set the stage for the housing market crash in 2007.

Subprime loans gave less-qualified borrowers access to homeownership that they’d not had previously. Most were adjustable-rate mortgages (ARMs) borrowers refinanced when the rates increased as they reset. Easier access to credit increased demand among subprime borrowers, driving up home prices and creating an aura of what some termed “irrational exuberance” around the housing market.

Unfettered by consumer protections and other regulation for these new products, profits from mortgage-backed securities encouraged lenders to continue issuing new subprime loans and investors to continue investing in them.

That exuberance came to an abrupt halt in 2007, when prices passed their peak and rising interest rates turned what had been considered low-risk securities into high-risk ones. A subsequent spate of subprime lender bankruptcies made subprime loans unavailable, which reduced demand for homes, caused home prices to fall, and caused rates to increase.

Struggling homeowners found themselves unable to refinance or sell for enough to pay off their mortgage loans. As these homes went into foreclosure, banks suffered major losses. The housing and mortgage markets collapsed, ushering in the Great Recession.

Subprime loans largely disappeared in the years following the crash, and federal regulation has put protections into place to help shield consumers from predatory lending practices. The Dodd-Frank Act, for example, established standards requiring that lenders not extend a mortgage loan unless they’ve taken reasonable steps to ensure the borrower can repay the loan, based on their credit history, income, and other factors, according to the Cornell Law School Legal Information Institute.

However, subprime loans, now called non-prime loans, are still available. They’re considered non-qualified loans because they don’t meet Dodd-Frank standards. These risky loan products have made a bit of a resurgence over the last few years. While federal law doesn’t cap their rates, state laws may.

Types of subprime mortgages

Subprime mortgage loans come in several varieties. Most have loan features that not only cost homeowners more in terms of their interest rate, but also leave them paying much longer than they would with a conventional loan — or require a balloon payment.

Interest-only mortgage: An interest-only mortgage loan allows you to make interest-only payments for some period after you take out the loan. This might save you money if you can refinance at a lower rate or sell after a few years. However, if things don’t work out as planned, you could find yourself several years into the loan with no reduction at all in the principal balance.

Payment-option mortgage: This is an adjustable-rate loan that gives you several repayment options, one of which is to pay a minimal amount, even if it doesn’t cover the interest due. This option frees up cash but leaves you owing more than you borrowed. You’ll likely have to make up for that with a balloon payment

40-year fixed-rate mortgage: A 40-year, or even 50-year, mortgage lets subprime borrowers make smaller payments by stretching them out over a longer period of time. They were introduced circa 2007 as a way to give subprime borrowers the primary benefit of an ARM — a lower payment, at least initially — without risking a rate jump.

Pros and cons of subprime mortgages

Subprime mortgages are risky for borrowers and lenders, but they do have a legitimate role in the housing market.

Pros

• They let prospective homeowners buy a home sooner.
• They give homeowners with damaged credit a chance to improve their credit score by making regular mortgage payments.
• Longer loan terms are more affordable.

Cons

• The loans are expensive compared to conventional and government-backed options.
• Poorly qualified buyers are at high risk of default and, as a result, foreclosure.
• The loans have the potential to exploit consumers.

Alternative mortgage options

Subprime loans aren’t the only type of mortgage loans available to consumers with damaged credit or lower income. Here are some better options:

• FHA loan: With a 500 credit score and a 10% down payment, or a 580 credit score and 3.5% down, you could qualify for a mortgage backed by the Federal Housing Administration. Rates are comparable to conventional mortgage rates, but you’ll have to pay a mortgage insurance premium.
• USDA loan: If your credit score is 640 or better, you can qualify for a Rural Development loan for low-income borrowers. It’s backed by the U.S. Department of Agriculture. You don’t need a down payment, but the home must be in an area designated rural by the USDA.
• VA loan: The U.S. Department of Veterans Affairs guarantees loans for eligible service members and veterans. You can finance 100% of your home purchase. The VA doesn’t set a minimum credit score to qualify, but lenders typically have their own minimums.

Subprime mortgage FAQ

Do subprime mortgages still exist?

Yes, subprime mortgages still exist. Other names for them are non-prime, high-cost, and non-qualified mortgages.

Why are subprime loans not recommended?

Subprime loans charge higher interest — much higher, in some cases — than qualified mortgages. They may have other features, such as long terms and interest-only payments, that also can be financially detrimental to the borrower.

What’s an example of a subprime loan?

One example of a subprime loan is an ARM that allows you to make payments so small that they don’t even cover your interest and don’t reduce the principal. That means you go deeper in debt each month.

Is subprime lending legal?

Yes, subprime lending is legal. What’s more, subprime lenders can loan money without a rigorous underwriting process to make sure the borrower can repay the loan.