Like HowStuffWorks on Facebook!

How are subprime loans put together?

Like other mortgages, subprime loans are made up of the principal that you borrow, along with an interest rate. The difference is that subprime loans have higher interest rates since subprime borrowers typically have worse credit ratings than other borrowers. Even without a low credit score, some people are tagged as high-risk borrowers if they can't prove their income and assets or they borrow a large percentage of their income [source: Brooks].

One of the most common types of subprime loans has an adjustable-rate mortgage, or ARM. These are defined by a low monthly payment at first, with low interest rates. After two or three years, the rates adjust every six months to a year and they can go up by as much as 50 percent of the initial rate [source:]. ARMs are often notated as 2/28 or 3/27, where the first number represents how long you get the introductory rate for, and the second number is the rest of the years when you'll pay a changing rate.

Subprime ARMs can also be designed as interest-only, where the introductory payments all go toward the interest and not the principal. That way, you pay off some of the interest at a lower rate than you would if you paid it in the following years. Another catch to subprime loans that you don't find with other mortgages is a prepayment penalty. If you decide you want to finish paying off your loan before the end of the loan period, you have to pay a fine. Also, some subprime loans include balloon payments where you have to pay the remainder of your loan all at once after a certain amount of time; most borrowers attempt to refinance when that payment is due. When refinancing is possible, it's often accompanied by exorbitant interest rates.