Understanding Subprime Mortgages
What’s often termed a bad credit mortgage is formally known as a subprime mortgage, a financial product extended to prospective homebuyers with lower credit ratings. Due to these less-than-ideal credit profiles, traditional mortgage options are typically unavailable, as lenders perceive a heightened risk of the homebuyer failing to meet loan obligations. To counterbalance this increased default exposure, lenders commonly impose higher interest rates on subprime mortgages.
The accompanying table presents current conforming rates for individuals possessing strong credit scores. If your credit score is weaker, anticipate a significantly elevated interest rate on your loan, and the loan structure is more likely to be an adjustable-rate rather than a fixed-rate. The table also incorporates a credit score filter, allowing you to locate offers aligning with your specific FICO credit range.
The following table displays prevailing local 30-year mortgage rates. You can utilize the provided menus to select alternative loan durations, modify the loan amount, adjust your down payment, or change your location. Additional functionalities are accessible via the advanced dropdown menu.
Distinctive Aspects of Subprime Mortgages
Subprime loans are characterized by interest rates that exceed those of prime loans. Lenders must consider numerous variables in a specific process termed “risk-based pricing,” which dictates the terms and rates of the mortgage. While subprime rates will invariably be higher, the exact increase is primarily determined by the borrower’s credit score. Other influential factors include the types of delinquencies recorded on the borrower’s credit report and the size of the down payment. For instance, lenders typically view late rent or mortgage payments as more severe than overdue credit card payments.
In some situations, borrowers might secure a higher interest “piggyback” second mortgage to help them qualify for a lower-cost primary mortgage.
Subprime loans are highly prone to featuring a balloon payment penalty, a prepayment penalty, or both. A prepayment penalty is a charge levied against the homebuyer for repaying the loan before its stipulated term concludes. This early payoff can occur if the borrower sells the home or opts to refinance. A mortgage with a balloon payment mandates that the borrower settle the entire outstanding balance in a single lump sum after a specific period, typically five years. If the borrower is unable to make the full balloon payment, they must refinance, sell, or risk losing the property. For first-time homebuyers engaging with non-traditional lenders, it is generally advisable to have a legal and financial expert review all documentation prior to signing the application.
A Deeper Dive into Credit Scores
Credit scoring is a formalized method for assessing credit risk. It employs mathematical models to determine an individual’s creditworthiness based on their current credit accounts and historical credit behavior. Although the system originated in the 1950s, its widespread adoption didn’t occur until the last few decades.
Credit scores are numerical values ranging from 300 to 900. A higher number signifies a better score. Creditors interpret this number as an indicator of whether an individual is likely to repay borrowed funds. These scores are calculated by analyzing the following data points:
- Late payments
- Non-payments
- Current amount of outstanding debt
- Types of credit accounts held
- Length of credit history
- Inquiries on the credit report (new credit applications)
- History of applying for credit
- Negative credit behaviors, such as issuing bounced checks
Creditors generally prefer to see a score exceeding 650, which is considered a very good credit score. Individuals with credit scores of 650 and above typically have a strong likelihood of securing quality loans with advantageous interest rates.
Scores between 620 and 650 suggest that a person possesses good credit, yet they may also signal potential concerns that creditors might wish to investigate further. A creditor could require the applicant to submit additional supporting documentation before a loan receives approval.
When scores fall below 620, consumers may discover that obtaining a loan is still possible, but the process will be more protracted and involve numerous additional obstacles. Scores beneath this threshold indicate a greater credit risk, necessitating a more thorough review of various aspects.
Beyond fewer economic opportunities, individuals with poor credit also tend to experience higher stress levels, which can negatively impact their health.
Verifying Credit Report Accuracy
Many individuals have inaccuracies on their credit reports of which they are entirely unaware. Identity theft is a prevalent issue in the United States, and consumer debts are frequently sold into a less-than-transparent industry. The initial step in identifying any unresolved issues is to obtain a copy of your credit report. AnnualCreditReport.com provides free access to your credit reports from Experian, Equifax, and TransUnion. While numerous other websites market credit reports and scores, many employ negative billing practices, enrolling you in recurring monthly charges that can be difficult to cancel. Should you discover errors in your credit report, you can challenge them using this complimentary guide from the FTC.
Check Your Credit Report & Credit Score For Free
Visit AnnualCreditReport.com for your report and Credit Karma for your score.
Candidates for Bad Credit Mortgages
Certain individuals with challenging credit profiles or a limited down payment might encounter difficulties securing financing from conventional lenders. A viable alternative to explore is obtaining a Federal Housing Administration (FHA) loan. These loans feature lenient underwriting requirements, allowing people to purchase a home with a less-than-perfect credit score and a down payment as low as 3.5%. Some FHA borrowers have credit scores below 620. Veterans may wish to investigate cost-effective VA loan opportunities. Rural homebuyers can explore USDA loans.
Each government-backed loan option has distinct qualification criteria, which you can review in the respective guides mentioned above. If you desire a comparative overview, especially if you’ve recently experienced bankruptcy or foreclosure, we’ve published a guide on buying a home after bankruptcy or foreclosure.
Another common loan type among subprime borrowers is the 2/28 ARM (Adjustable-Rate Mortgage), which offers an introductory “teaser” rate for two years, followed by yearly adjustments thereafter. Many of these loans experience a sharp increase in rates at the two-year mark, with the homebuyer typically intending to refinance at that point. However, if the homeowner continues to have unresolved credit issues or if the mortgage market tightens, they might be unable to refinance. The escalated rate can lead to a prohibitively higher monthly payment, and an inability to refinance can result in the loss of homeownership.
The following points represent general guidelines that can serve as a rough rule of thumb when determining whether a consumer might be a suitable candidate for a bad credit loan:
- A credit score below 620
- Multiple delinquencies of 30 days on a mortgage within the past year
- One delinquency of 60 days on a mortgage within the past 12 months
- A charge-off or foreclosure within the past 24 months
- Bankruptcy within the past 24 months
- A debt-to-income ratio exceeding 50%
- Inability to cover family living expenses within a month
However, overall creditworthiness is not solely determined by credit scores. A few missed credit card payments do not automatically consign a consumer to double-digit interest rates. The only definitive way to ascertain one’s standing is to apply for the loan and consult with a mortgage loan specialist.
Important Information for Couples
Joint borrowers applying for a mortgage together may encounter a higher interest rate than they would individually. If one applicant possesses a significantly lower FICO score than their partner, the loan officer will likely offer a higher interest rate based on that lower score. In numerous scenarios, it could be more advantageous for the individual with the superior credit score to apply independently. The Washington Post recently highlighted an illustrative example:
For instance, a $300,000 30-year fixed-rate mortgage in Illinois, underwritten using a 760 FICO score, might have qualified for a 3.3 percent rate and a $1,309 monthly principal and interest payment in early April, according to Myfico.com. If the application had been underwritten using a score of 650 instead, the rate might have been approximately 4.3 percent, resulting in a $1,485 monthly payment. Annually, this amounts to an additional $2,112 in costs — in this particular case, solely because the couple chose a joint application, and the 650 score drove up the rate. To circumvent this issue, the individual with the higher FICO score should apply for the loan independently and possess sufficient personal income to qualify for the full loan amount.
Strategies to Enhance Your Credit Score
The following are straightforward methods to improve credit scores:
- Prompt Bill Payments: The foremost method is to pay bills punctually. Delinquent bill payments can have a tremendous adverse impact on credit, and the longer an individual consistently pays bills on time, the better their credit score will become. For example: A person with a credit rating of 707 can boost their score by an additional 20 points simply by paying all bills on time for a single month. Paying crucial items like mortgage and rent is especially important, as mortgage lenders particularly scrutinize payment trends for these.
- Low Credit Card Balances: Maintaining low balances on credit cards is vital. High credit card debt can significantly harm your credit score, potentially lowering it by as much as 70 points.
- Avoid Excessive New Credit Accounts: It’s important to refrain from opening credit cards that are not genuinely needed. Numerous new accounts can decrease the average age of your accounts, which can, in turn, lower your credit score by around 10 points.
- Positive Payment History: While having credit cards is beneficial, managing them effectively is crucial. Consistently making on-time payments on credit cards and installment loans can raise credit scores. Paradoxically, someone who lacks credit cards entirely tends to pose a higher risk to lenders than someone who has managed their cards poorly but has an established history.
- Recently Closed Accounts in Poor Standing: Accounts, even when closed, continue to impact your credit. The account will still appear on your credit report and be factored into your score.
- Verify Against Identity Theft: Some individuals illegally open accounts for services like cell phones, broadband, or other common utilities using the identities of others. These bills go unpaid and are eventually sold to debt collectors, who then immediately impact the credit profiles of the victims in an attempt to recover funds. Check your credit report to ensure you don’t have fraudulent accounts due to identity theft. Often, merely complaining to the credit bureaus might not resolve the error, but a CFPB complaint typically clears such issues quickly.