A basic “prime” mortgage is the vanilla ice cream of the mortgage industry. It its most basic form, you put down 20% of the home price as a deposit and borrow the remaining 80%, which you pay off over the next 30 years at a fixed rate of interest. However prime mortgages also come in other flavors: 15-year loans, adjustable interest rates (or ARM), etc. But the key element of a prime mortgage is the interest rate. They offer the best (i.e. lowest) interest rates around - which is why only people with decent credit histories can get them. When you see mortgage rates mentioned in articles, they are typically prime mortgage rates and over the past few years have ranged from 5.25% to 6.75%.

A subprime mortgage is one that is available to people with less than stellar credit histories. They might be people who have a combination of credit problems which may include having declared bankruptcy, a sketchy job history, or the inability to come up with a down payment for a house. Typically these are people with a credit score of 620 or lower. Because people who have questionable credit histories are more likely to default on their loans, they can only qualify for mortgages with higher interest rates. Like a prime mortgage, a subprime loan can be a fixed rate or adjustable rate loan (ARM) however subprime loans are predominantly ARMs. Only compared to a prime mortgage ARM, a subprime loan interest could easily skyrocket into the double digits after the brief introductory period has passed (usually 3 years). In addition to higher rates, most subprime mortgages have prepayment penalties, which force the homeowner to pay fees if they pay off the mortgage early either by selling the house or refinancing. Sometimes a subprime loan will include a balloon payment which requires the homeowner to pay off the entire loan after a certain amount of time, usually 5 years has passed. And frequently, subprime mortgage brokers charge significantly higher loan origination fees.

The Price of Bad Credit
For most people, getting a subprime loan is not a choice. Their financial situation is such that they simply cannot qualify for a better (such as Prime or Alt-A) rate. Although in recent years, increasing numbers of borrowers have unknowingly found themselves with subprime loans when they could have qualified for better terms. How does this happen? When you apply for a mortgage, the broker will not explicitly tell you that you are being offered a subprime loan. Nor will he tell you that he may have a financial incentive to sell you a subprime loan, even if you qualify for an Alt-A or Prime loan. So it is critical that you shop around with a few different brokers to make sure you aren’t unwittingly signing up for a higher interest rate than is necessary to get the loan.

Whether you get a subprime loan because of challenges with your credit or through an unscrupulous broker, the net effect is that your loan will cost you significantly more than a Prime or Alt-A loan. The figure below describes the terms and costs associated with two typical loans, one issued to a Prime borrower and one issued to a subprime borrower. Over the course of 4 years, the subprime loan would cost $16,960 more than the prime loan.

In theory, subprime mortgages are not necessarily a bad thing. They help people with rocky financial pasts get into homes. They enable people who have run into financially troubled waters to refinance their house, cashing out equity to live on. However over the past decade, the subprime mortgage industry has grown from a small cottage industry into a huge $1.2 trillion dollar industry.

Continue reading - Subprime Mortgages Explained - Part II

Additional Resources:

The Buzz about Subprime Loans- Part II

Mortgage Professor

Wikipedia

US Dept. of Housing