Subprime Loan

Subprime Loan

A subprime loan is a mortgage loan that is made to an individual with poor or bad credit. These are typically individuals that would have credit grades of B (typically a FICO score below 620), C (typically a FICO score below 580), and below. Because of their poor credit scores, subprime borrowers do no qualify for conventional loans or government loans such as FHA and VA loans.

According to the Mortgage Bankers Association, subprime loans represented 14% of the total mortgage market by 2003. In the period 1994 to 2003, subprime loan growth significantly outpaced prime loan growth with a 25% rate of growth according to a report in USA Today (Subprime loan market grows despite troubles, December, 2004).

Subprime Loan Rates, Fees, and Costs

Subprime loans represent increased risk to lenders. By late in 2006, the rate of subprime loan delinquencies of over 60 days was up to nearly 8% according to UBS. The Center for Responsible Lending (CRL) projects that nearly 20% of subprime loans made in the period 2005 to 2006 will fail. Lenders compensate for this in many ways:

  • Lenders may require higher down payments.
  • Lenders charge higher interest rates, which can be up to 5 or 6% higher than the rate for traditional loans. Lower down payments on subprime loans may increase the interest rate even more. The lower an individual's credit score, the higher interest rate they can expect to pay.
  • Lenders charge higher fees and closing costs for most subprime loans.

Prepayment Penalties

A high percentage of subprime loans have prepayment penalties. This is because many borrowers treat subprime loans as a short-term solution (the proper way to look at such a loan). Prepayment penalties often will prevent refinancing into a lower interest rate loan for some period of time. It is important for borrowers to understand if their loan has a prepayment penalty, and for how long that prepayment penalty lasts.

Borrower Beware

Freddie Mac estimates that up to 15% of subprime borrowers have credit scores that would qualify them for traditional loans. No borrower should take the first loan offer presented. Borrowers, even subprime borrowers, should always shop around for the best deal. Doing so can save them significant amounts of money on closing costs, as well as obtain for them a better interest rate.

Subprime Loans Should Be Viewed as a Short-Term Solution

No borrower should stay with a subprime loan longer than they have to. By being diligent about making their mortgage payments on time, as well as on time payments for other debts, and paying down debt balances, a borrower should be able to "repair" their credit rating over time so that they can refinance with a traditional mortgage. Over time, refinancing into a traditional mortgage will save the borrower significant amounts of money on interest payments.

Alternatives to Subprime Loans

If a subprime loan is a borrower's only option, their main alternative is to postpone purchasing a home and work on improving their credit score. This can be done by making all of their debt payments on time, as well as paying down debt balances. Over time, this will improve their credit score so that they can obtain a more advantageous loan.

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