What Is A Subprime Loan?

What is a subprime loan?  It is a mortgage loan made to a borrower with poor or bad credit. These are typically individuals that would have credit grades of 620 and below. Because of their poor credit rating, subprime borrowers do not qualify for traditional loans or government loans such as FHA and VA loans. 

At this time, subprime loans represent 15% to 25% of the total mortgage market.   Because of their poor credit rating, subprime loan borrowers are an increased risk to banks. Many times, the reason the borrower has a poor credit rating has to do with the fact that they have a significant amount of debt, and are having a hard time making the .  As a consequence, the subprime borrower tends to get behind with his mortgage payment.  It is forecast that over 20 percent of the subprime loans made in the past several years will fail.   

Because of the risk required, banks will overcompensate in many ways: They may require higher down payments. They require higher interest rates, which can be as much as 10 percent higher than the rate for traditional loans.  The lower the borrowers credit score, the higher the loan rate.  Also lenders charge bigger fees and closing costs for subprime loans.  Additionally, a high percentage of subprime loans have prepayment penalties. 

Most home loans do not have a prepayment penalty, because most home buyers tend to keep their loan for longer periods of time.  A subprime loan is typically assumed to be a short term solution, and the lender wants to ensure they get enough compensation for the risks they incur.  If your loan has a prepayment penalty, be sure to find what the penalty is and the length of the penalty period. 

Before getting a subprime loan, check with other lenders, because a significant number of subprime borrowers actually have credit scores that would allow them to get traditional loans.  By shopping around, you can save significant amounts of cash on closing costs as well as get a lower interest rate. 

A subprime loan should always be thought of as a short term solution.  A borrower should opt out of a subprime loan as quickly as possible, because refinancing a subprime loan will save the borrower a substantial amount of money on interest payments and will lower the monthly payment.  If you have bad credit, you can try to fix your credit by ensuring all of your monthly payments are kept current and the loan balances are paid off.  By arranging this, you should be able to qualify for a much lower interest rate. 

If a subprime loan is the only option available, it may be better to postpone the purchasing the home.  By repairing your credit and paying off some of your other debts, you will improve your credit score and be able to find a much lower loan rate.