Sub-prime mortgages

Egregious credit problems, such as a recent foreclosure, will prevent you from getting a mortgage. But lesser credit flaws won't necessarily stop you from getting a home loan. An industry of sub-prime mortgage lenders has sprung up to serve the vast constituency of Americans who have credit problems.

Sub-prime defined

Generally, sub-prime mortgages are for borrowers with credit scores under 620. Credit scores range from about 300 to about 900, with most consumers landing in the 600s and 700s. Someone who is habitually late in paying bills, and especially someone who falls behind on debts by 30 or 60 or 90 days or more, will suffer from a plummeting credit score. If it falls below 620, that consumer is in sub-prime territory.

Few lenders will use the term "sub-prime" to describe you or your loan, because it's considered bad salesmanship. You might hear the word "non-prime" or, more likely, an adjective won't be used to describe the mortgage at all.

Mortgages for people with excellent credit are somewhat of a commodity, with rates that don't vary much from lender to lender for equivalent loans. That's not the case with sub-prime mortgages. You might receive widely differing offers from different sub-prime lenders because they have different ways of weighing the risk of giving you a loan. For that reason, it's important to comparison-shop when your credit score is less than 620.

How sub-prime mortgages differ

Sub-prime loans have higher rates than equivalent prime loans. Lenders consider many factors in a process called "risk-based pricing" when they come up with mortgage rates and terms. This makes it impossible to generalize about sub-prime rates. They are higher, but how much higher depends on factors such as credit score, size of down payment, and what types of delinquencies the borrower has in the recent past (from a mortgage lender's standpoint, late mortgage or rent payments are worse than late credit card payments).

A sub-prime loan also is more likely to have a prepayment penalty, a balloon payment, or both. A prepayment penalty is a fee assessed against the borrower for paying off the loan early -- either because the borrower sells the house or refinances the high-rate loan. A mortgage with a balloon payment requires the borrower to pay off the entire outstanding amount in a lump sum after a certain period has passed, often five years. If the borrower can't pay the entire amount when the balloon payment is due, he/she has to refinance the loan or sell the house.

Researchers contend that prepayment penalties and balloon payments are associated with higher foreclosure rates. The sub-prime mortgage industry contends that borrowers get lower interest rates in exchange for prepayment penalties and balloon payments, but that point is debatable.

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