Subprime Specifics

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 have become increasingly popular in recent years due to 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 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 remaining period of the loan with the fluctuating rate.

Justin Sullivan/Getty Image News Wells Fargo is a leading lender for home loans.

Interest-only options are also often attached to subprime ARMs. 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. (Check out How Interest-only Loans Work for more information.)

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

­

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 current leveling of appreciation values in the U.S. housing market has made it difficult to gain much ground. 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're able 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 decide whether or not you fit into the category of subprime. According to MSN Money, your potential loan may be subprime if you have:

• Missed any credit payments in the past three years
• Declared bankruptcy in the last seven years
• Consistently overdrawn your bank account­
• Defaulted on any credit
• Previously been foreclosed on or have repossessions in your history
• Consistently been late on your bills or have had utilities shut off

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 your credit score.