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Subprime (Bad Credit) Mortgages

Egregious credit problems, such as a recent foreclosure, will prevent you from getting a mortgage. But lesser credit flaws won't necessarily stop you from getting a home loan. An industry of subprime mortgage lenders has sprung up to serve the vast constituency of Americans who have credit problems.

Subprime defined

Generally, subprime mortgages are for borrowers with credit scores under 620. Credit scores range from about 300 to 900, with most consumers landing in the 600s and 700s. Someone who is habitually late in paying bills, and especially someone who falls behind on debts by 30, 60, or 90 days or more, will suffer from a plummeting credit score. If your score falls below 620, you’re in subprime territory.

Few lenders will use the term "subprime" to describe you or your loan, because it's considered bad salesmanship. You might hear the term "non-prime" or, more likely, the mortgage won’t be given any label at all.

Mortgages for people with excellent credit are somewhat of a commodity. Lenders offer these people the same good rates, without much difference from lender to lender. That's not the case with subprime mortgages. You might receive widely different offers from subprime lenders because they have different ways of weighing the risk of giving you a loan. For that reason, it's important to comparison-shop when your credit score is less than 620.

How Subprime Mortgages Differ

Subprime loans have higher rates than equivalent prime loans. Lenders consider many factors in a process called "risk-based pricing" when they come up with mortgage rates and terms. This makes it impossible to generalize about subprime rates. They are higher, but how much higher depends on factors such as credit score, size of down payment, and what types of delinquencies the borrower has in the recent past (from a mortgage lender's standpoint, late mortgage or rent payments are worse than late credit card payments).

A subprime loan also is more likely to have a prepayment penalty, a balloon payment, or both. A prepayment penalty is a fee assessed against the borrower for paying off the loan early, either because the borrower sells the house or refinances the high-rate loan. A mortgage with a balloon payment requires the borrower to pay off the entire outstanding amount in a lump sum after a certain period, often five years. If the borrower can't pay the entire amount when the balloon payment is due, he or she has to refinance the loan or sell the house.

Researchers contend that prepayment penalties and balloon payments are associated with higher foreclosure rates. The subprime mortgage industry contends that borrowers get lower interest rates in exchange for prepayment penalties and balloon payments, but that point is debatable.

Predatory Loans

Subprime customers have to be on the lookout for predatory lenders who set out to cheat borrowers. There are several predatory tactics, and sometimes a lender will combine them. Some lenders soak naive borrowers with outrageous fees and sky-high interest rates. These lenders are likely to tell borrowers that their credit score is lower than it really is.

Another predatory tactic is to pressure a homeowner to refinance the mortgage frequently, charging high closing fees each time and rolling the closing costs into the mortgage amount. That goes hand-in-hand with another predatory tactic: Issuing a loan regardless of the borrower's ability to repay it. When the borrower predictably defaults, the predatory lender forecloses and sells the property.

An ethical mortgage lender doesn't want to foreclose on a property because foreclosure is a money-losing proposition. An ethical lender makes money by charging interest and loses money by foreclosing. A predatory lender, on the other hand, profits by repeatedly collecting closing fees, then seizing the house.

To defend yourself from predatory lenders, find your credit score before shopping for a mortgage, and ask family and friends for referrals to mortgage lenders. Also, comparison-shop by going to at least two banks or lenders, preferably more.