How do Subprime Mortgages Work?
Subprime Mortgages are mortgages for the acquisition of residential real estate, sanctioned to customers who have a troubled credit history. They are loans sanctioned to customers whose credit scores are beyond repair and those who cannot avail loans by means of conventional mortgages from financial institutions. The risk of default on these loans is significantly higher for prime customers, which is why banks charge fees that are high enough to make up for the extra risk. The rates of interest and closing costs in these loans may be relatively high and they may also require a higher down-payment.
Kinds of Subprime Mortgages
Interest-only loan: An interest-only mortgage can be easily afforded by the customers as they don’t need principal payments for the first few years of the loan. However, a good percentage of customers tend to assume that they will either sell their home or refinance before the repayment of the principal, which is when the risk of the increase in monthly payments rises. In such cases, customers sometimes aren’t able to afford the increased payment. In case the home’s value decreases, they won’t be able to sell or refinance their home, leaving them with no choice but to default as they cannot afford higher payments.
Option ARM mortgages: Such a mortgage enables customers to select the amount of money they think they can afford to pay on a monthly basis. However, the rest of the amount will be added to your principal when there is a small payment. After a period of five years, the option is no longer available and the loan will be greater than it was when you took it out.
Negative amortisation mortgages: These loans are similar to interest-only mortgages, only worse in the sense that the principal is never repaid. Monthly interest payments are lower than usual, which causes the debt to grow over a period of time as it is added to the principle, thereby causing the principle to grow each month.
Ultra-long fixed rate mortgages: These mortgages extend for between forty and fifty years, unlike the usual thirty-year mortgages.
Balloon mortgages: These mortgages come with low monthly payments. However, they need a higher payment after five-seven years to repay the remainder of the loan.
Frequently Asked Questions - FAQs
- How do lenders know if my credit history is poor?
- Why do banks charge higher rates to people who have a troubled credit history?
- Why do subprime lenders lend to customers with poor credit history?
Lenders usually check an applicant’s credit history when they are approached for a loan. It is recommended that customers check their credit report prior to applying for a loan and making sure that the scores are accurately reported.
Lenders are usually sceptical when it comes to dealing with customers who have a problematic credit history. The risk posed to lenders is higher due to the customer’s proven inability to make repayments in the past.
Several major lenders sanction mortgages to subprime as well as prime borrowers. Lenders cater to subprime customers by offering debt consolidation at a high rate of interest, but such lending also has the potential to further affect the already damaged credit history of the borrower.