What it means
Lenders sort mortgage applicants by credit history, income and deposit size. Applicants with late payments, defaults, low scores or high existing debts are placed in the subprime tier and charged more.
Before the financial crisis, many subprime mortgages were adjustable-rate loans with a low fixed rate for the first two or three years. After that period the rate reset to a higher level, which could raise the payment sharply.
Borrowers were often expected to refinance before the reset, which only works if house prices and lender willingness hold up. Since the crisis, lending rules in many countries have changed.
Lenders are generally required to check that a borrower can afford the loan at the higher reset rate, and some risky features such as loans with no proof of income have been restricted or banned. For a buyer, the main question is affordability across the whole loan, not only in the first year.
It helps to ask what the payment will be after any rate change, what fees are added, and whether there is a penalty for repaying early or refinancing. Deposit size matters.
A larger deposit lowers the loan-to-value ratio (the loan as a percentage of the property's value), which reduces the lender's risk and can lead to a lower rate. Many weak-credit buyers who save for a bigger deposit find that their offers improve noticeably.
Subprime mortgages can still serve a purpose. Someone recovering from a past problem may be able to buy a home, make steady payments for a few years, and then move to a cheaper loan once their record improves.
In practice
Real-world examples.
Example
A first-time buyer with a short credit history is offered a mortgage at a rate well above the market level. She accepts, pays reliably for two years and then refinances at a lower rate. By then, her credit record has improved and the value of the home has risen, which helps her case with the new lender.
Example
A self-employed painter with irregular income and a past default is offered a mortgage with a larger deposit requirement. He compares three lenders and picks the one with the lowest fees and no early repayment charge.
Example
A couple receive a letter telling them that their introductory rate ends in three months. They calculate the new payment, find that it is $550 higher, and ask their lender about a fixed-rate alternative before the reset happens.
Formula
Calculation
The effect of a rate reset can be estimated with the interest-only payment:
Monthly interest payment = Loan x Annual rate / 12
A buyer has a $240,000 loan with a 6% introductory rate. The payment is $240,000 x 0.06 / 12 = $1,200 a month. After the reset to 9%, it becomes $240,000 x 0.09 / 12 = $1,800 a month, an increase of $600, or 50%. A full repayment loan has a slightly different payment, but the size of the jump is similar, so the borrower must be able to afford the higher figure.Case study
Seen in the real world.
Maple Row is an illustrative, fictional housing development where a young family bought a $300,000 home with a 10% deposit. Their credit record was weak after a period of unemployment, so the lender offered a subprime mortgage with a low rate for two years and a much higher rate afterwards.
Before they signed, an adviser told them to work out the payment at the reset rate. The calculation showed that the higher payment would take about 45% of their income, which was more than they wanted to commit.
In this illustrative story, they chose a smaller home at $240,000 and a mortgage with a fixed rate throughout. The monthly payment was a little higher in the first two years, since the fixed rate started above the teaser rate, but it never changed, and they avoided the risk that a rise in rates or a fall in house prices would trap them.
Watch out
Common mistakes.
- Judging affordability by the introductory payment rather than the payment after any rate reset.
- Assuming the loan can always be refinanced before the rate rises.
- Overlooking fees, penalties and insurance that raise the total cost beyond the headline rate.
Questions
People also ask.
Is every mortgage for a weak-credit borrower subprime?
Many lenders use the term for loans priced above standard rates, so a loan with a clearly higher rate for a borrower with weak credit is usually described that way.
Are subprime mortgages still available?
Yes, although rules are tighter in many countries and lenders must check affordability more carefully.
What happens if I miss payments?
The lender can charge fees, report the late payments to credit agencies and, in the end, take the property through a legal process.
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