Subprime loans are home loans that have easier qualifying guidelines than standard or conventional home loans. They allow borrowers to qualify for financing with lower credit ratings, lower income and, in some cases, no-income verification. Because the qualifying guidelines are less strict with subprime loans, lenders view them as more risky than conventional loans. This is why subprime loans have higher interest rates and higher fees than conventional loans. In general, subprime loans are any loans that do not meet conventional loan guidelines.

Conventional Loans

To better understand subprime loans, you should have an understanding of what a conventional loan is. These are loans with guidelines set by a government-sponsored agency known as Fannie Mae, which stands for Federal National Mortgage Association. Fannie Mae provides a detailed set of guidelines for lenders to follow when making a home loan. If these guidelines are met, the loan can then be “sold” to Fannie Mae after it is made. Since most lenders “sell” their loans (to free up money that can then be loaned on more properties), they must make sure the loans meet the Fannie Mae requirements.

Fannie Mae loans require a minimum credit score of 620 and must meet strict income and loan-to-value ratios. Conventional loans have the lowest rates and fees on the market. Borrowers that qualify under these guidelines are considered “A-paper,” which means they are fully qualified based on income, credit, assets and have a lower risk of default.

Subprime Income Requirements

Most loans are based on a debt-to-income ratio which is the borrower’s percentage of the total fixed monthly debts, such as home loans and car loans, divided by the borrower’s gross monthly income. Conventional loans require that this ratio cannot exceed 36 percent. Subprime mortgage loans allow for a higher debt ratio, sometimes as high as 50 percent.

For example, if a borrower has fixed monthly debts of $2,500 and a gross monthly income of $5,200, he would have a debt ratio of 48 percent ($2,500 divided by $5,200). With this debt ratio, he wouldn’t qualify for a conventional loan, but he might qualify for a subprime loan.

Some subprime loans don’t require any income verification. These are called stated income loans and are usually used by business owners whose incomes are often buried in business write-offs. In this case the borrower is required to state his monthly income without having to back it up with income documentation.

Subprime Credit Requirements

All home loans are based on credit ratings. These are usually summarized by a three-digit credit score provided by a credit bureau. There are three primary credit rating bureaus: Experian, TransUnion, and Equifax. Each bureau keeps track of an individual’s credit history and assigns a three-digit number to represent a borrower’s credit from 350 to 850; the lower the number, the worse the credit rating.

When a home loan is started, lenders will run a credit report that includes the scores of all three bureaus. Most lenders take the mid-score, which is the middle score of the three bureaus. For example, if a borrower has ratings of 560, 615, and 620, the mid-range score would be 615 because it is the score in the middle. Conventional loans require a mid-score of 620, however a subprime loan may allow for a lower score. Generally the lower the score, the higher the interest rate and loan costs.

Loan to Value Requirements

Since subprime loans are considered more risky than conventional loans, the loan-to-value ratios are usually lower. This means the loan amount must represent a lower percentage of the total appraised value of the property. For example, a loan amount of $150,000 made against a property worth $245,000 would have a loan-to-value ratio of 61 percent ($150,000 divided by $245,000). Conventional loans will go as high as 95 percent loan to value, but most subprime loans can’t exceed 70 percent loan to value.

Considerations

Subprime loans provide an alternative form of financing a home loan to borrowers that don’t meet the stricter guidelines set forth by FannieMae on conventional loans. This however comes with a higher price including higher interest rates and higher fees.