What is a subprime mortgage?

Subprime mortgages are home loans extended to people with bad credit that can be very risky for the borrower but very profitable for the lender.

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Key Takeaways

  • Subprime mortgages are offered to people with bad credit, who may not be able to pay them off

  • Subprime mortgages have high interest rates, to incentivize the bank to lend to subprime borrowers

  • While subprime loans are harder to find since the Great Recession, they are still not a good choice

  • Instead of taking a subprime loan, borrowers should work to improve their credit before buying a home

A mortgage is a loan you get to pay for your home. When you apply for a mortgage, your lender assesses your credit and finances and quotes you an interest rate based on the monthly mortgage repayments it expects you to make. Banks don't usually want their customers to default on their payments, so they generally won't extend a home loan to someone who can't pay it back.

But not every bank is so scrupulous, especially when operating in a less-regulated legal environment. When banks extend mortgages to people with poor credit or who would otherwise struggle to make payments, such loans are typically considered subprime mortgages. Often, the bank has a tacit understanding that subprime borrowers will default, and the lender may eventually get to foreclose the home.

This means the lender takes ownership of the home and sells it off to pay to pay the remaining mortgage balance. Because borrowers are more likely to default on a subprime mortgage, not only are they paying interest to the bank for years, they'll often end up with nothing to show for it. For that reason, we advise staying away from mortgages if you have bad credit until you rebuild your finances.

How to spot a subprime mortgage

Conforming loans are those offered to people whose amount of debt is 50% or less or their income, expressed as a debt-to-income ratio. Subprime mortgages don't conform to the standards set forth by Freddie Mac and Fannie Mae, the government-sponsored enterprises that help guarantee mortgages. As such, they are considered nonconforming loans.

Such a loan is considered very high risk. Typically, subprime borrowers have a credit score between the range of 500 and 640. Ironically, because of the increased risk, subprime mortgages come with an unusually high interest rate, which makes them harder to pay off.

Combined with the generally weaker financials of subprime borrowers, these loans resulted in an unprecedented amount of defaults and foreclosures -- subprime mortgages were a major factor in the financial crisis of 2007 and 2008. If you know that your credit is less than favorable, you should be wary of banks trying to take advantage of you by offering you a mortgage at a high interest rate.

Loans called subprime mortgages are virtually impossible to find now. Instead, they've undergone a rebrand as “nonprime” loans. But make no mistake: these loans are very good for the bank and very expensive for the borrower. If you're ready to own a home, the first thing you should do is calculate your debt-to-income ratio by adding up all your debts and liabilities and dividing it by your income, and set your expectations based on that.

If your debt-to-income ratio is high, you're likely to default on your mortgage payments and could lose your home. To make sure you're not paying too much, use the Policygenius mortgage calculator to estimate your monthly payments.

How to improve your credit

The best thing you can do when you're ready to buy a home is to improve your credit until you become eligible for prime loans. That means paying off your debts, starting with any delinquent loans.

Also, don't apply for new debt, including revolving debt like credit cards. Every hard inquiry temporarily lowers your credit score, and a huge part of your credit score is the average age of your debt, the older the better. You'll also get a huge boost by keeping your credit utilization ratio down – that's the percentage of your available credit you have left on your credit line.

It's important to have good credit when applying for a mortgage, because it will get you the most agreeable terms and make you eligible for more types of mortgages. However, it's much more important to lower your debt-to-income ratio, because it's a good measure of whether you can afford to even repay your mortgage.

You're entitled by law to get a free copy of your credit report, once per year, from the three major credit bureaus. Before you buy a home, have a good look at your credit history and note any derogatory marks. Some of these may be errors committed by the credit bureau or the merchant who reported the charge, and you have the right to contest anything you believe to be a mistake.

Government-backed mortgages for people with bad credit

Rather than take out a subprime mortgage, you may be eligible for an FHA loan, a VA loan, or a USDA loan, backed by the Federal Housing Association, the Department of Veterans Affairs, and the Department of Agriculture, respectively. While the government doesn't write these mortgages directly, it does protect the lenders who write them.

You may be eligible for one of these government-backed loans if you have limited financial resources and poor credit. Maximum income levels and maximum loan amount requirements vary from state to state. The following table shows how each government-backed loan differs for someone purchasing a single-family home.

LoanEligibilityMinimum Credit ScoreDown PaymentMaximum Mortgage LimitMortgage Insurance Required?
VA LoanMust be a veteranVaries by lenderGenerally none up to the first $144,000 of a mortgageNo limit, but VA will only guarantee the first $453,100 to $679,650 (higher limits available in Hawaii)No
FHA LoanMust be employed at the same place for at least two years500Credit score 500-579: 10%; Credit score 580 and up: 3.5%$294,515 to $679,650Yes
USDA LoanProperty must be in rural area; must earn up to a certain income640None$136,000 to $625,000 (lower minimums available in Puerto Rico and Pacific territories)No