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We Tell You The Risk of Subprime Mortgages by a New Name

We Tell You 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.

Key Takeaways

  • A subprime mortgage is a type of loan granted to individuals with poor credit scores who wouldn’t qualify for conventional mortgages.
  • Subprime mortgages are now making a comeback as nonprime mortgages.
  • Fixed-rate mortgages, interest-only mortgages, and adjustable rate mortgages are the main types of subprime mortgages.
  • These loans still come with a lot of risk because of the potential for default from the borrower.
  • New nonprime mortgages have restrictions placed on them and must be properly underwritten.

What Is a Subprime Mortgage?

A subprime mortgage is a type of loan granted to individuals with poor credit scores—640 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 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 ICE LIBOR. 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.

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