Ever been rejected a loan because of low credit ratings? There are several people who get rejected on loans everyday for this very reason. These credit ratings are very important for people who wish to get bigger loans easily.
That is where subprime home equity loans come in handy. Let me walk you through the whole process.
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What is a Subprime Loan?
A subprime loan is a type of loan given out to people, especially borrowers with low credit. Many mortgage lenders reject people that have low credit ratings, because of their potential inability to repay the loan. This is also why the interest rate is relatively higher for such loans.
There is a prime interest rate that is set for prime buyers with a reasonable credit rating, currently the prime interest rate is 3.25%, but the subprime interest rate is always higher. This is due to the risk of the low-credit borrower to end up defaulting on the loan altogether.
How does a Subprime Loan work?
When the borrower enters the mortgage market, they are looking for lenders to lend them money for their homes. And because of a low-credit rating, they’re often having a hard time looking for lenders. Now with the subprime loan, borrowers are not in much of a fix.
That being said, the lender accepts the risk of the borrower turning into a bad debt; meaning he wouldn’t be able to pay. To save the lender from a greater loss, he charges a very high amount of interest rate from the borrower on the mortgage.
These high interest rates on subprime loans can translate into thousands of dollars in additional interest payments over the life of a mortgage.
Types of Subprime Loans
As discussed above, subprime loans are granted to high-risk borrowers, and even though the most popular thing about subprime loans is having it for mortgages, they aren’t the only reasons why people need it.
Apart from mortgages, subprime loans are granted in the shape of student loans, credit card debts and car loans too. Here are some of the types of subprime loans:
Interest-only loan: This type of loan allows mortgage borrowers to only pay the interest in the beginning of the loan duration making it affordable for them to repay during the initial months. But soon enough the amount increases because the interest is added to the loan itself. If it is a mortgage loan and the market itself isn’t performing too well, you could be stuck in a huge problem.
Adjustable-rate loan: With this kind of subprime loan type, the interest rate remains flat for the first couple of years before changing to a floating rate later on. So if the loan is for 20 years, you can expect to pay a flat interest rate in the first 2-3 years before it picks up its pace.
Fixed-Rate Loan: A fixed-rate loan is the one where the interest rate is fixed throughout the duration, like the name suggests. But with this the drawback is that the duration of the loan is relatively higher. A prime loan has a maximum limit of up to 30 years, but with a fixed-rate option it could easily be 40-50 years.
Dignity Loan: In a dignity subprime loan, the borrower must put down a down payment equivalent to about 10% of the loan and agree to a higher interest rate for the initial portion of the loan. If monthly payments are made on time for this period- usually 5 years, the interest rate decreases down to the prime rate. In addition, the amount already paid on interest will go toward reducing the balance of that loan.
Pros and Cons of Subprime Home Equity Loan
Just like every other loan, a subprime loan too has a list of pros and cons.
- Benefits borrowers with poor credit history
- Borrowers with high debt-to-income ratio also qualify
- Can help fix the credit score if timely payments are made
- Higher interest rate than prime interest rate
- High chance of borrowers to default on the loan because of a high interest rate
- High monthly payments
- Processing fees and high upfront fees may not be affordable for many borrowers
Subprime Mortgage Crisis
The United States faced a severe subprime mortgage crisis from 2007-2010, and in turn triggered a financial crisis for the country. This started when banks started selling too many mortgages easily to meet the demand from 2005-2006, and when home prices fell in 2006, it created several defaults.
The blame of this mortgage crisis was put on financial institutions, governments, credit agencies, and even consumers. The two major reasons for this was the rise in subprime lending to high-risk borrowers and an increase in house speculation. The percentage of low-quality subprime mortgages rose from 8% to 20% in 2000. Over 90% of high subprime mortgages had an interest rate that rose drastically over time.
Housing speculation also increased with the share of mortgage originators from 20% in 2000 to 35% by 2007. As a result investors and borrowers who initially had a reasonable and high credit rating were more likely to default than non-investors when the prices fell.
So when US home prices fell, it became much harder for borrowers to refinance their loans, even on an adjustable rate mortgage. Everyone took a serious hit in the subprime mortgage crisis; banks bailed out, investors were having a hard time in real estate, and the economy was in a major fix.
How to avoid defaulting on a Subprime Home Equity Loan?
Even if you’re not a high-risk borrower on your own fault, there are chances that you default on the subprime home equity loan because of higher interest rates. Here’s how you can avoid getting to that stage of default:
- Budget your income to include the potential loan payment.
- Check your credit score and fix errors in your credit history.
- Make timely payments each month to improve your credit rating.
- Shop around for alternative lenders.
- Consider asking someone with strong credit and income to cosign on the loan.
- Set a reminder at least 3-4 days prior to the due date so that you don’t forget paying, and if you’re short of money, you have time to ask from your friends or family.
To benefit high-risk borrowers with a low credit rating, subprime loans are made common in the country but they are often with a very high interest rate. Of course there is a chance of the borrower defaulting on it too because of the interest rate, but that’s a risk the lender has to take.
Make sure you know exactly what you’re getting yourself into; check out market rates, talk to several lenders before you make a decision. It is obviously advisable for you to fix your credit ratings before applying for a subprime loan, because this way you will dodge high interest rates.
It depends on borrowers and their needs of when to opt for a subprime home equity loan.