A subprime mortgage is a loan given to individuals who have a credit score below 640 or do not have a credit score at all. Federal Deposit Insurance Corporation defines these individuals as ‘borrowers who have been delinquent, bankrupt, have a low credit score or have a low income’. The people who have defaulted on two or more payments in last one year are also included into this category.

These loans are risky because the borrower has a bad record with money and there is always a chance that the bank will lose the money, hence, subprime loans are given on very high-interest rates.

Fixed interest mortgage
Fixed interest subprime mortgage is given for a long term; 40-50 years. A general long-term mortgage is given for 30 years. This long term reduces the monthly payments for the borrower but usually comes with a high-interest rate. The fixed interest rates given for subprime mortgage vary from lender to lender. In order to find the best deal, a borrower must research and talk to different banks.

Interest only mortgage
The second type of subprime mortgage is an interest-only mortgage. In this deal, the borrower pays the interest only for the first five, seven or 10 years. He/she can choose to pay toward the principal but that is not necessary. When this interest term ends, the borrower begins paying for the principal. He/she also has an option of refinancing the mortgage at a better rate and pay off the old one in one go.

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Adjustable rate mortgage (ARM)
An adjustable rate mortgage starts with a fixed interest rate and moves to a floating rate after a certain period of time. In an ARM, the floating rate is determined by an index plus a margin. The commonly used index is ICE LIBOR. So, with an ARM, the borrower has to pay a small amount initially and when the mortgage shifts to floating, this amount increases substantially. One advantage of an ARM is that the interest rate does not just go up, it also goes down from time to time, reducing the payment amount.

Dignity mortgage
Dignity mortgage is a unique type of subprime mortgage. In this loan system, people make a hefty down payment of about 10% at the beginning and pay a high-interest rate for a fixed period of time, which is usually 5 years. If the borrower makes all the payments on time in the 5 years, the bank reduces the balance on the mortgage with the money paid toward the interest. The interest rate is also lowered to the prime rate.

A subprime loan is a risky business for banks but it is also a huge earning opportunity for them. So, banks give out these loans very frequently and many people with bad credit score go for it.

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