Subprime Mortgage Loans: 4 Pitfalls to Lookout For

Subprime mortgage loans can be an effective tool to borrow for the home you want if you have a poor credit history or your income is currently too low to qualify for a conventional loan. But subprime mortgage loans often come with above-market interest rates, higher fees or more restrictive terms. Here are four pitfalls to avoid so you can make the best use of a subprime loan if one is right for you.


Don't Assume the Worst

A "prime" interest rate is one offered to a lender's most qualified borrowers. The name "subprime" literally means a borrower is less qualified than the best qualified. If events in your past marred your credit score, leaving you a poor credit rating now, you might need a subprime mortgage loan. You need it not because you are unqualified but because you are less qualified.


The first pitfall to avoid is to make sure you actually need a subprime mortgage. Subprime mortgage loans come with a higher price tag than conventional loans. The interest rates and fees are higher and the terms are typically more strict. Don't assume you're in the subprime category. Check with a lender who offers subprime and conventional loans.


Make it Work for You

A poor credit rating is not the only reason people are directed to subprime mortgage loans. If the house you want to by is in poor condition or in a marginal neighborhood, the lender could require a subprime (higher interest) loan.


Make this work for you. It is quite possible you have your eye on a house to buy in poor condition that you intend to fix up and add value. You might believe a neighborhood is on the rise and you are getting in on the ground floor. In these instances, you can make an initial purchase with a subprime loan and refinance it later, if your loan allows for that.


Avoid the "Low Initial Rate" Trap

Many homebuyers are directed to subprime mortgage loans because they don't make enough money to justify a conventional 30-year fixed-rate loan. A typical subprime loan will have an "adjustable rate component." This means you are offered a below-market interest rate - and lower monthly payment - for the first few years, and it adjusts to the market rate in later years. Often, these adjust to a predetermined fixed rate in those later years.


If you take out one of these subprime mortgage loans, you are banking on the fact that your disposable income will have grown enough so that you can pay the higher payments when the higher rate kicks in. This is no time for wishful thinking. Even though you qualify for the low rate "now," be as certain as you can you can pay the high rate "then."


Know the Fees and Penalties

Just as interest rates are higher on subprime mortgage loans, so are fees. All lending is based on the risks assumed by the lender. Subprime loans, by definition, are considered riskier and therefore more expensive. Either in the rates, the fees or the terms (or all three) the lender will protect themselves against loss from this higher risk.


This can affect your pocketbook. In the adjustable rate loan mentioned above, it is typical for loans to have a prepayment penalty for some or all of the life of the loan. That means if you want to refinance the loan before it adjusts to the higher predetermined rate, you might have to pay a substantial amount of money to get out of your agreement. It could make it financially unwise to refinance to a lower rate.


Additionally, subprime lenders offering competitive interest rates may be getting that money back through origination or closing fees that are rolled into the total loan amount. You end up paying a lower rate but on a larger amount of money.