The interest rate is often the determining factor for anyone trying to get a mortgage. They do not want to pay too much interest because the monthly payments are often too high and the added expense makes owning a home too expensive. But some people have no choice but to take whatever loan program is offered to them, which can mean a subprime loan. So the biggest question is, are interest rates higher for these loans? The answer is two-sided.
The Reasons Subprime Loans have Higher Interest Rates
In general, yes subprime loans do have a higher interest rate that they coincide with simply because they are for borrowers that do not qualify for a conventional loan. Typically, these loans are for borrowers that have:
- Lower than 600 credit scores
- Income that is not fully verifiable
- Blemishes on their credit report that a conventional or FHA loan will not allow
- Special circumstances that FHA and conventional loans will not allow
- Borrowers that have debt ratios that exceed a standard loan program’s allowance and/or the 43% threshold for a qualified mortgage
Because of these circumstances, the interest rates are higher to make up for the risk that you pose to the lender.
Let’s look at an example: Joe has a credit score of 580. His credit history is not the greatest – his late housing payments are in the past (more than 12 months ago), but his revolving credit had some 30 and 60-day late payments. His debt ratio is only 33% for all of his debt and he has a steady job.
Joe probably will not qualify for any loan except a subprime loan from a lender that is willing to write non-QM loans. Because he has a blemished credit history he is slightly riskier than a borrower with a better credit score. But the good news is that his debt ratio is not excessive. Because of this, he finds a bank that is willing to give him a subprime loan, just at a higher interest rate than he would have been able to get with an FHA or conventional loan.
The Reasons Subprime Loans Might not Have Higher Interest Rates
On the other hand, sometimes a subprime loan is the only option. Take, for example, John, a self-employed person. John owns his own cleaning company and does not draw a salary. The income he receives is periodic and fluctuates quite a bit. John has a decent credit score of 650 and his debt ratio is 38% overall. Unfortunately, John cannot verify his income in the standard fashion because he does not have W-2s or paystubs to show the lender. Instead, he has tax returns which show a depleted amount of income because of the amount of write-offs that John takes in order to lower his tax liability.
In this case, John is not necessarily a higher risk in terms of bad credit, such as the example of Joe above. John just cannot verify his income in the standard way – in fact, he needs a stated income loan, which allows him to use his bank statements to prove his receipt of income over the past 12 months without using his tax returns. Because of this need, however, he cannot use a conventional or FHA loan – he has to use a subprime loan. Because his credit is good and his debt ratio is not excessive, he might not have a lot of adjustments on his interest rate, which means he could have a rate that is comparable to what someone else receives on a conventional or FHA loan.
The Factors that Matter
In general, just like any other loan, there are certain factors that determine your interest rate on a regular or subprime loan. These factors include:
- Credit score ( the lower the score, the more your interest rate adjusts)
- Debt ratio (the higher your debt ratio, the more your interest rate adjusts)
- Work history (the more stable your work history, the fewer adjustments a lender will make to the interest rate to make up for your risk level)
- Amount of the down payment (the more money you put down, the less riskier you become)
- Amount of the reserves you have on hand (the more reserves you have, the less riskier you are for the lender)
The lender takes into consideration a variety of factors to determine your interest rate. Every loan program, whether you are talking about conventional, government-backed, or subprime loans, has a base rate that the program begins with – from there, the lender makes adjustments to the rate based on the level of risk you provide to the lender. What some lenders can accept as a risk, others cannot – it greatly depends on the other loans in their portfolio or on the requirements of the investors, if they are selling the loans on the secondary market.
The good news is that you are not automatically doomed to a high-interest rate just because you need a subprime loan. If you can get your qualifying factors in line so that you can look as responsible as possible, you will have an easier time obtaining the low interest rate that you desire, even on a subprime loan.