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How Subprime Mortgages Work


Subprime Specifics

Subprime Credit Cards

Another way subprime lending rears its ugly head is in the credit card industry. Subprime credit cardholders can expect to pay a variety of additional fees not typically found with prime cards. Yearly fees, up-front fees, and higher late and over-the-limit fees are common.

The late payment grace period is also usually not available to a subprime cardholder. One fee typically leads to another, resulting in a late fee that's figured into the balance, leading to over-the-limit fees.

The system itself seems geared toward making money off the people that had financial difficulties to begin with. If you have a subprime card, it's very important to stay on top of your payments for an extended period. This way, you may actually be able to improve your credit.

Subprime mortgages come in all shapes and sizes. The one factor that's generally consistent across the board is that the interest rate will be higher than the prime rate established by the Federal Reserve. The prime rate is what lenders charge people with good credit ratings.

One of the more common subprime loans has an adjustable-rate mortgage (ARM) attached. ARMs became increasingly popular during the housing boom because of their initial low monthly payments and low interest rates. Introductory rates for ARMS typically last two or three years. The rate is then adjusted every six to 12 months and payments can increase by as much as 50 percent or more [source:Bankrate.com]. If you hear about a 2/28 or a 3/27 ARM, the first number refers to the number of years at the introductory rate, the second to the number of years in the remaining period of the loan which are subject to the fluctuating rate.

Interest-only options are also often attached to subprime ARMs. These refer to when the first period of payments go only toward the interest rather than the principal of the loan. Let's look at a 2/28 interest-only ARM. This loan allows you to pay only on the interest during the two year introductory period at a lower set rate. After that, the full amount of the loan is recalculated over the remaining 28 years with a new rate. (Read How Interest-only Loans Work for more information.)

According to the mortgage calculator at Bankrate.com, the increase in the monthly payments on a 2/28 interest-only subprime ARM can be dramatic:

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Loan Rate Monthly payment
First two years $200,000 7% $1,330.60
Third year $200,000 11% $1,922.96

As you can see, it's likely when the introductory period runs out that you'll be in store for a much higher monthly payment. While it's possible to refinance after this period, the decline in appreciation values in the U.S. housing market during the housing bust made this difficult. It's also important to remember that every time you refinance, you must pay a new set of closing costs to your lender.

Subprime loans often have a prepayment penalty included in the terms. This means that if you choose to pay the loan off early, you must pay extra fees.

They may also have a balloon payment attached. This is when the remainder of the loan is due after the introductory period in one lump sum. Borrowers generally plan on refinancing at this point, but this isn't always possible. Even if it is, you can end up with much higher rates.

There are other factors aside from your credit score that determine whether you fit into the category of subprime. Lenders may deem a loan risky for borrowers who, although they have good credit scores, can't provide proof of income and assets, or borrow an unusually large percentage of their income, as well as a myriad of other reasons [source: Brooks].

It's also important to remember that your credit is affected by anything you have co-signed with another person. People who get divorced are often surprised to find out that their former spouse has defaulted on loans that ruin their credit score.

In the next section, we'll examine the subprime mortgage crisis and what's being done to fix it.

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