When you apply for a mortgage, you’ll likely hear terms that are a little foreign to you. One of the most common is the prime loan and subprime loan. Understanding the types of loans can make a huge difference in your choice of mortgage. Because your mortgage loan is probably one of the largest investments you’ll make, it’s important to understand the terms.
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The Prime Loan Defined
A prime loan is one offered by Fannie Mae or Freddie Mac. They are the investors. They purchase these loans on the secondary market. However, they only purchase them if the loans meet their parameters. This is where ‘prime’ comes into play.
A prime borrower has the following characteristics in common:
- Good credit score – Usually over 680
- Low debt ratio – Usually 28% housing ratio and 36% total debt ratio maximum
- Stable employment – Usually for the last 2 years
- Increasing income over the last 2 years
What’s the Benefit of the Prime Mortgage Loan?
Prime mortgage loans are for the borrowers with good qualifying factors. In return for their low risk, lenders provide low-interest rates and closing costs. They usually start at the lowest rates available on the market, but may have some adjustments made based on your actual qualifying factors.
In short, prime loans are more affordable and have terms that are more favorable for borrowers. It’s the tradeoff lenders offer as a result of the borrower being ‘low risk.’ Just what makes a borrower low risk? We uncover that below.
Making Yourself a Low Risk Borrower
If you look at how a mortgage works, you’ll see the risk lenders undertake. Let’s say you borrow $300,000 for a period of 30 years. That means the lender is out a large portion of that money for the better part of 30 years. They will see small principal payments and a small stream of income from the interest, but it takes a long time for them to get a large portion of the funds back.
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In order to be a low risk borrower, you must show the lender you are
financially responsible. You can do this by:
- Keeping your credit score high
- Avoiding late payments on your credit report
- Keeping your debts to a minimum
- Don’t overextend your amount of revolving debt compared to your available balance
- Keeping a steady job
- Keeping an eye on the deductions you take on your taxes if you are self-employed or work on commission
- Putting down a large down payment
- Saving enough money to sit in your savings or other investment vehicles to serve as reserves
Borrowers that fit these qualifications will likely get the best terms on their mortgage.
Fannie Mae and
Freddie Mac will only purchase loans from borrowers that pose little risk, as is done with any of these factors.
The Available Prime Loans
Typically, when you ask for a prime loan, you’ll be offered the 30-year fixed loan. You pay back the full loan amount over a period of 30 years, interest included. However, there are other options as well:
- 15, 20, or 25-year fixed rate mortgages
- 30-year adjustable rate mortgages
The 15, 20, or 25-year fixed rate mortgage works just like the 30-year fixed. The rate remains unchanged for the term of the loan. The only difference is the amount of time you have to pay back the loan. Lower terms mean higher payments.
The 30-year adjustable rate mortgages feature a rate that changes over time. Let’s say you took a 3/1 ARM. You would have a fixed, introductory rate for the first 3 years of the loan. After that point, the rate could adjust on an annual basis. The
rate is determined by the chosen margin and index. The lender adds the pre-determined margin to the index at the time of the rate change. The rate can go up or down, but it does have ‘floors’ and ‘ceilings’ to help keep it from changing too drastically.
Whether you can secure a prime loan depends on your factors as well as those of the market. When the market is busy, lenders may get a little more restrictive with their guidelines. They don’t have to fight the competition for loans, so they can be choosy when it comes to taking risks. If the market is slow, however, lenders may get a little looser with their guidelines. For example, they may allow slightly lower credit scores than they would require during high demand times.
In the end, a prime loan may suit you best if you have the qualifying factors. You’ll have access to the market’s lowest interest rates and fees. If you can’t get a prime mortgage, though, don’t worry. There are many other subprime loans out there that still offer favorable terms for borrowers today.
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