A subprime mortgage is a loan for the purpose of purchasing a home, specifically for borrowers who do not meet the criteria for a standard mortgage. Subprime is a description of the creditor, and is an indicator of poor credit ratings, usually 600 and below. Prime customers describe borrowers with a credit rating of 700 and up.
Due to the higher risk with borrowers who have low credit scores, mortgage lenders charge higher interest rates on a subprime mortgage than on a standard mortgage. Although there is competition within this industry, the rates are consistently higher than those available from traditional financing.
Within the subprime mortgage industry, there are two product lines that are unique to this market; adjustable rate mortgages and 100% financing. An adjustable rate mortgage is one where the initial interest rate is close to prime for a set period of time. After that time, the rate increases for the remainder of the mortgage life. The options are 2/28 -- two years at an introductory interest rate and 28 years at a higher rate -- or 3 years at a lower rate and 27 years at the higher.
The borrowers often plan to repair their credit during the two or three years of the lower interest rate and then refinance with a traditional lender before the higher rate takes effect. Credit scores can be improved by maintaining a good payment record, paying off bad debts or allowing time to pass for bankruptcy or consumer proposal to be removed from the report.
The 100% financing mortgage allows borrowers to make no down payment but to finance the entire cost of the mortgage. This allows borrowers who do not have the capacity to save the minimum deposit of 5% of the purchase price to buy a house.
Although not unique to the subprime mortgage industry, longer length terms have increased the number of borrowers who qualify for mortgages. A traditional mortgage is the US is 25 years. However, lenders have offered mortgage terms as long as 40 years in an effort to lower monthly payments to an amount affordable by a larger group of borrowers. This longer term significantly increases the interest payments throughout the life of the mortgage.
Subprime mortgages have a higher rate of default than standard mortgages. In addition, subprime mortgage lenders often charge additional fees to qualify and included buyout clauses, where a penalty is due should the mortgage be paid off early, through refinancing with another company at a lower interest rate.
The subprime mortgage industry aggressively markets their products to consumers. A common practice is to blanket a specific neighborhood with information and sales presentations aimed at consumers who are unaware of their credit score.
Well qualified buyers may agree to a subprime mortgage based on the sales presentation, even though they would qualify for traditional financing. This practice is especially common in ethnically concentrated areas, where borrowers were routinely denied credit by traditional lenders.