You hear the term subprime and you probably shiver. The nightmares people have to tell about the high interest rates and crazy costs may make you think you’ll never explore that option. Today, though, subprime loans aren’t nearly as bad as they seem. In fact, they can be a great way to get the loan that you need.
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What is a Subprime Loan?
A subprime loan is basically a loan that lenders keep on their own books. In other words, they don’t sell it on the secondary market. The lenders can make their own guidelines and decide what they will and will not accept on loan applications.
Typically, subprime loans are good for those that don’t qualify for a standard conventional or government-backed loan because of poor credit scores, high debt ratios, or irregular income. Subprime loans aren’t a way to sneak in financing for a home when you really don’t qualify for it. You still have to prove that you can afford the loan beyond a reasonable doubt.
The Most Common Reasons to Take a Subprime Loan
Each subprime loan has its own requirements and therefore reasons to take it, but the most common reasons people take a subprime loan include:
- A credit score that doesn’t meet the conventional or FHA guidelines
- A recent bankruptcy or foreclosure
- Recent collections on the credit report
- Insufficient proof of your income (most for self-employed borrowers)
- A debt ratio higher than what Fannie Mae or the FHA allow
- Not enough of a down payment for Fannie Mae or FHA
- Self-employed borrowers that don’t have a 2-year history of self-employment
- An employed borrower that changes jobs frequently
Again, not every subprime lender is going to allow every one of these situations. However, subprime lenders often have more leeway than traditional lenders do when it comes to situations such as those above.
The Downside of Subprime Loans
Subprime loans can be great, especially when you can’t get a traditional mortgage, but they do have some downsides that you should understand.
- Subprime loans typically have higher interest rates. Subprime lenders take a higher risk of default when offering loans to borrowers. In order to make up for that risk, they charge higher interest rates than what you’d find on conventional or FHA loans.
- Subprime loans may charge higher closing costs. It depends on the lender, loan program, and the risk you pose, but you may pay more. If you are conscientious about the fees, ask questions, and negotiate, though, you may be able to keep the costs lower.
- Subprime loans may have different terms. It’s important that you read the fine print and ask lenders the right questions. For example, is it an interest-only loan? Is it an adjustable-rate loan? These types of loans can make it harder for you to get ahead on your principal balance or make it hard to afford the payment if the rates adjust too much.
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Knowing the fine print of any loan that you take is crucial to your success. Don’t be afraid to ask lenders questions or to shop around. You have the right to know what options you have available to you, especially since each lender can create their own rules and/or programs.
Are Subprime Loans the Reason for the Recession?
You may have heard that subprime loans were the reason for the recession. While they may have contributed to it, they aren’t the sole reason. Even if they were, today’s subprime loans are nothing like the subprime loans are before.
Today, lenders have to make sure beyond a reasonable doubt that you can afford the loan. In other words, the days of stated income and stated asset loans are behind us. You must be able to show a lender that you can afford the loan by proving that you have the income and/or assets to afford it. While you may not provide proof of your income in the standard way, such as with paystubs, you have to show receipt of income in some manner.
What are the Alternatives to a Subprime Loan?
If you think you need a subprime loan because you have a low credit score or high debt ratio, you may have some other options than the subprime loan:
- FHA loans – FHA loans have the most lenient credit score guidelines as well as the highest debt ratio allowance. If you have a credit score over 580 and a total DTI less than or equal to 41%, you may want to explore your option for this loan.
- VA loans – If you are a veteran, explore your option for a VA loan. You don’t need a down payment for this type of loan and they have flexible guidelines. The VA doesn’t have a minimum credit score requirement or a maximum debt ratio that they require. This could open more doors for better loan terms with a VA loan.
- Wait for your factors to improve. If you have the ability to increase your credit score or pay off debts and decrease your debt ratio, you may be able to just wait it out a few months to a year and then get a conventional or FHA loan with better terms.
Subprime loans aren’t a bad thing. If you are in a position that you need one, use it. The best-case scenario is to take the subprime loan for now, while working on your qualifying factors in the meantime. This way you could refinance out of the subprime loan when you are able and get better terms for the remaining time that you are in the home.