Two of the most common terms you will hear in the mortgage industry is prime and subprime. The two terms both refer to types of mortgages. However, they mean very different things. You either fall into one category or the other, rarely do people fall into both categories. There is not one category of loans that is necessarily better than the other. It comes down to which program fits your needs the most. If you are a subprime borrower, it does not mean you are a “bad” borrower. It simply means this program fits your needs better. Yes, you might pay higher interest rates, but you do so because it is what your financial situation allows. Here we will look at the major differences between the two programs.
What are Prime Loans?
Prime loans are also known as conventional loans. These are loans backed by Fannie Mae and Freddie Mac. They are your mainstream loans and the ones people know the best. Generally, people who qualify for these loans have great credit and low debt ratios. They meet the strict requirements of the secondary market which allows lenders to give them low-interest rates and sell the loans to Fannie and Freddie. These are not necessarily the “better” borrowers; they are just the ones with the qualifications required by Fannie and Freddie.
What are Subprime Loans?
Subprime loans are the loans that gained the bad reputation after the housing crisis. Experts believed lenders haphazardly handed out these loans, such as the No Income, No Asset Loans to borrowers who could not afford them. Subprime loans actually took quite a leave of absence because of the reputation they gained. Today, however, they are back and better than ever. You will not find No Income, No Asset Loans any longer, but you will find other alternative forms of documentation to help borrowers who are not mainstream obtain a loan. The lenders who offer these loans are usually smaller and keep the loans on their books.
The General Criteria
If we were to stereotype a prime borrower and a subprime borrower, it would look like the following:
- Great credit scores (over 700)
- Low debt ratios (28/36 max)
- Stable employment
- Plenty of assets on hand
- No late payments in their recent credit history
- Lower credit scores
- High debt ratios
- Unstable employment
- No assets
- Late payments on their credit report
However, every lender has their own requirements. One lender might approve a borrower with a lower credit score for a prime loan while another may consider him subprime. There is no rhyme or reason for what lenders decide.
Perhaps one of the largest differences between prime and subprime mortgages is the interest rates charged. Conventional loans, as they are called, usually have lower interest rates. This is because these loans have a lower rate of default. Interest rates often directly correlate with the level of risk. For example, a borrower with a 750 credit score will likely have a lower interest rate than someone with a 650 credit score. Even if both borrowers are conventional, they could have very different interest rates.
Just how much higher subprime rates are to prime rates really depends on the situation. Lenders look at loans like a big puzzle. They do not look at interest rates alone. Instead, they look at the big picture including:
- Employment history
- Credit history
- Debt ratios
Lenders also look at compensating factors. For example, one borrower may have a low credit score, but also have a low debt ratio and 12 months of reserves. This borrower may be able to go conventional because of his compensating factors. Even if he cannot go conventional, he may have a lower interest rate than someone without these compensating factors.
One thing that subprime loans are good at is helping those in unique circumstances. The most common example today is the self-employed borrower. Many borrowers are self-employed today. It is just the way of the world. As more companies close, more people are forced to open their own business to make a living. Because of this, not many borrowers have traditional income. Without subprime loans, these people would be without a home. Subprime loans, often called alternative loans, offer different ways for these borrowers to verify their income. They obviously will not have paystubs and W-2s like conventional loans require. Instead, they may have bank statements to prove their income. Conventional loans cannot allow this type of documentation. This forces these borrowers to go subprime. This does not mean they must take a higher interest rate though. The only reason they need subprime is for the unique documentation. Shopping around will yield these borrowers the greatest deals.
Today, there is no such thing as a good and bad borrower. It just depends on what program you need. Subprime might mean slightly higher interest rates or more fees, but that is not a bad thing. Lenders need to protect themselves, even if this means against the self-employed borrower. Going subprime means there is something risky about your loan. It does not mean you have bad credit or you will default on your loan. It just means you need an alternative way of looking at things. Borrowers who use conventional financing meet a very strict set of rules that cannot be bent. The government put forth much stricter guidelines after the housing crisis, making it difficult for the average consumer to go “conventional.” This does not mean subprime is mainstream, everything is about equal today – it is about what works for you and your family.