Subprime home loans came into the spotlight during the credit crunch as part of the problem with the lending industry. While many people have a negative connotation associated with subprime lending, not that many people actually understand it. Here are a few things that you should know about subprime loans and how they are used.
A subprime mortgage refers to any mortgage that is offered by a lender that is considered riskier than the majority of loans. There is a market for prime mortgages and then there is a separate market for subprime. The majority of subprime loans are made to those who have low credit scores. When you cannot qualify for a regular mortgage because of your credit score, subprime mortgages are often available as an alternative. Although there is no definitive parameter of where a subprime loan starts, typically if you have a credit score of less than 640, these are the loans that will be available to you. Subprime mortgages can be offered in a variety of situations.
One aspect of the subprime mortgage market involves loans that are not traditional in nature. In the prime market, you will find a lot of 30-year fixed mortgages and some 5/1 adjustable rate mortgages. In the subprime mortgage market you will see a lot of alternative loans being offered. This is where balloon loans and interest-only loans come into play. With these types of loans, you pay only the interest each month which gives you a lower payment. However, at the end of the loan, you have paid down no principal. You will owe the entire balance of the loan at once. These types of loans are offered as a way for subprime borrowers to afford the monthly payment on the house that they want. However, they often get the borrowers into more financial trouble than they were already in.
The lending industry is notorious for its strict lending ratios. They will analyze everything about the potential borrowers financial situation and put it into lending ratios. The debt-to-income ratio is a big one that plays a vital role in determining credit worthiness. When you do not fit their predetermined guidelines, your loan will be denied. With subprime mortgages, you can get around these strict ratios. Subprime lenders will have much more relaxed ratios to work with, which works in favor of the borrower.
Another very common aspect in the subprime market is high interest. Charging customers higher than normal interest is normal and expected in this market. This market faces a much higher than average risk of default. Therefore, the lenders have to compensate for this extra risk that they are taking on. They compensate for the risk by charging more in interest to their customers.