What is a subprime mortgage?

How subprime mortgages work

Subprime mortgages are designed for borrowers with low credit scores. Many conventional mortgages require a credit score of 620 or higher, so lenders may consider scores below that to be subprime. Each lender sets its own definition of “subprime,” so be sure to ask about a lender’s specific credit score requirements if you’re considering applying for a mortgage.

Lenders assume subprime borrowers are relatively risky, so subprime mortgages typically come with high interest rates and closing costs to offset the perceived risk of default.

Subprime mortgage crisis

Subprime mortgages played a significant role in the Great Recession, which lasted from December 2007 to June 2009.

Relaxed underwriting standards allowed the market share of subprime mortgages to grow from around 7% in 2000 to as much as 20% in 2006. Many subprime borrowers were unable to make their payments as rates began to climb in the mid-2000s. When home prices dropped, home equity decreased, and those who had balloon mortgages couldn’t refinance as they’d planned.

A mass of foreclosures led to a collapse in the prices of mortgage-backed securities and, eventually, the entire stock market.

Subprime vs. prime mortgages

FICO, the most widely used credit score provider in the U.S., separates credit scores into five different categories:

• Exceptional (800 and up)
• Very good (740 to 799)
• Good (670 to 739)
• Fair (580 to 669)
• Poor (579 and below)

Prime mortgages are reserved for borrowers who have credit scores of at least 670. Because prime borrowers are deemed low risk, their mortgage qualification requirements are less stringent than the requirements for subprime borrowers. Their rates are less costly, too.

For example, a conventional 30-year mortgage may come with a 7% interest rate and require only a 3% down payment for a prime borrower. For a subprime borrower, the interest rate might be closer to 10% (or higher) and require a larger down payment to help offset the lender’s risk.

Here’s how these different requirements could play out for a $300,000 home:

Subprime mortgage types

There are several types of subprime home loans. Here are a few of the most common.

Who is a subprime borrower?

“A subprime mortgage can be for individuals who have a recent bankruptcy, foreclosure or cannot fully document their income,” said Eric Jeanette, mortgage lender and CEO of Dream Home Financing.

There is specific guidance from the Federal Deposit Insurance Corporation (FDIC) on what constitutes a subprime borrower:

• Two or more 30-day delinquencies in the last 12 months or one or more 60-day delinquencies in the last 24 months
• Judgment, foreclosure, repossession or charge-off in the last 24 months
• Bankruptcy in the last five years
• Relatively high default probability as evidenced by, for example, a FICO score of 660 or below
• Debt-to-income (DTI) ratio of 50% or greater or otherwise limited ability to cover family living expenses

Note that this FDIC guidance was given in 2001, and more recent guidance from the CFPB suggests a credit score below 620 constitutes a subprime borrower.

However, if poor credit is the only factor holding you back, you don’t have to get a subprime loan. 

“Some people believe that having poor credit means they need a subprime loan,” said Jeanette. “That is not the case, because FHA loans permit credit scores as low as 500 … so, if the borrower's issue is credit scores, then that is not a reason to search for a subprime loan.”

» MORE: How to check your credit score

How to get a subprime mortgage

The process for getting a subprime mortgage is very similar to getting a conventional loan. You can work with a local bank or credit union or an online mortgage lender of your choice. You should ask upfront if the lender offers subprime mortgages.

You can then apply for a subprime mortgage by following these steps:

• Submit a loan application.
• Submit the financial information requested (pay stubs, tax returns, bank statements, etc.).
• Complete a credit check.
• Review your mortgage offer (interest rate, term length, etc.).
• Sign the loan documents.

Borrowers are required to receive neutral counseling from a U.S. Department of Housing and Urban Development representative prior to taking out a subprime mortgage.

To discourage predatory lending, the CFPB, which governs consumer lending in the U.S., dictates that lenders must evaluate all subprime mortgages based on the borrower’s ability to repay. This means lenders must take a deep dive into your finances to ensure you can repay the loan before it is approved.

» MORE: 9 mortgage questions to ask your lender

Alternatives to a subprime mortgage

While subprime loans can help you get into a house sooner, they can require high down payments and charge very high interest rates.

There are some alternatives to subprime mortgages that can help you become a homeowner, and they may actually save you money as well.

• An improved credit score: If you want to avoid the high price of a subprime loan, you can simply wait until your credit score and history have improved. This means borrowing responsibly and making on-time payments, as well as lowering your DTI ratio. It may take some time, but it can save you a lot of money in the long run.
• Federal Housing Administration (FHA) loans: FHA loans are available to borrowers with credit scores of 500 or more. Down payments can be as low as 3.5%, and interest rates are much lower than subprime loan rates.
• Department of Veterans Affairs (VA) loans: If you are a military service member, veteran or surviving spouse, you may qualify for a VA home loan. These loans have no set minimum credit score or down payment requirement, and their interest rates may be lower than comparable conventional loans.
• U.S. Department of Agriculture (USDA) loans: USDA home loans are available for certain properties in rural areas as defined by the USDA. They also come with income limits that vary by state and county. You usually need a credit score of 640 or above to qualify, but there’s no minimum set by the USDA, and some lenders may work with borrowers who have subprime scores.

Bottom line

Although subprime mortgages got a bad rap for their role in the Great Recession, many people consider them safer now because of increased regulation. These loans can be useful tools for some borrowers with low credit scores, but not all.

If you’re getting a subprime mortgage, be prepared to make a large monthly payment due to a high interest rate. This means subprime mortgages are typically best for borrowers with low credit scores but relatively high and stable incomes.

If paying a higher interest rate concerns you, it may be best to either work on your credit before applying for a mortgage or look for a government-backed home loan you qualify for that accepts lower credit scores.