What is a subprime mortgage?

One of the main factors mortgage lenders weigh when making a lending decision is your credit score, which makes it difficult to receive a home loan if you have a poor credit history.

Subprime mortgages, also called nonprime mortgages, are loans for homebuyers with low credit scores. Before you choose a subprime mortgage, however, it’s essential to understand how they work and what to expect.

How subprime mortgages work

Subprime mortgage loans are designed for borrowers with a lower credit score. Many conventional mortgages require a credit score of 620, so lenders may consider scores below that to be subprime. Each lender sets its own definition for subprime, so be sure to ask about credit score requirements.

Lenders assume subprime mortgages are riskier for them than other conventional mortgages, so these home loans typically come with higher interest rates and closing costs to offset the higher chance of default.

Subprime mortgage types

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

Adjustable-rate mortgages

Adjustable-rate mortgages (ARMs) are mortgage loans that start with a rate that’s fixed for an initial period then changes at a specified frequency. The rate changes based on the index, which is a benchmark interest rate that adjusts with market conditions, and the margin, which is the number of points added to the index by the lender.

According to the Consumer Financial Protection Bureau, most subprime mortgages are ARMs. This can be problematic if you have unsteady income because you can’t budget for a consistent monthly payment.

It’s more common for subprime mortgages to have an adjustable rate than a fixed rate.

Fixed-rate mortgages

Fixed-rate mortgages have one interest rate that doesn’t change throughout the life of the loan. Budgeting for fixed-rate loan payments can be easier since the payment will always remain the same.

Interest-only mortgages

Interest-only mortgages only require interest payments for the first few years of the loan. This interest-only period usually lasts five to 10 years.

Once that period ends, you start paying principal and interest. Your monthly payment jumps because you’re paying the principal off in a shorter time frame than you'd have with a typical mortgage loan.

Dignity mortgages

A dignity mortgage is a type of subprime mortgage loan that requires you to pay a higher interest rate for the first few years of the loan.

If you make all your payments in full and on time, this higher-rate period ends. All of your interest payments from the initial period go toward reducing your loan balance, and your interest rate lowers to the prime rate — the rate typically given to the lender’s most creditworthy borrowers.

Subprime vs. conventional mortgages

The biggest difference between subprime and conventional mortgages is that subprime loans are intended for borrowers with lower credit scores — generally 620 or less. Some lenders may have different standards for what counts as a subprime score.

Since subprime loans are available for borrowers with lower credit scores, lenders consider them riskier and tend to charge higher rates than they do on conventional loans. Subprime mortgages are also less widely available than conventional mortgages.

Additionally, borrowers must undergo homebuyer counseling through a U.S. Department of Housing and Urban Development (HUD)-approved agency to obtain a subprime mortgage.

Bottom line

Although subprime mortgages got a bad rap for their role in the 2008 financial crisis, many people consider them safer now because of increased regulation. These loans can be great tools for some borrowers with low credit scores — but not all.

If you’re getting a subprime mortgage loan, you should be prepared to pay a larger monthly payment because of the higher interest rate. This means subprime mortgages are typically best for borrowers with low credit but a relatively high and stable income.

If paying a higher interest rate concerns you, it’s typically best to work on your credit first or look for a government-backed home loan you qualify for that accepts lower credit scores.