Mortgages are the largest portion of a so-called “subprime tax” that costs people with credit scores of 620 or less nearly $3,400 a year on average for essential financial products, according to a new study.
A subprime borrower spends roughly $1,330 more per year on mortgage interest for a 30-year fixed-rate mortgage loan on a $400,000 home with 20% down, excluding annual property taxes and additional ownership expenses, the BankRate study found.
Over a five-year period, moreover, a borrower with a low credit score would pay $6,648 more in mortgage interest; over 30 years, $39,886 more, when compared to a prime borrower, the study says.
The average annual percentage rate for a 30-year fixed-rate mortgage for a borrower with a 620-639 credit score is 7.53%, according to FICO data as of early July. For a borrower with a 700-759 credit score, it stands closer to 7%.
Overall, the subprime tax costs “at least” 4% of annual income for a typical American household with low credit and impacts roughly one in five adults.
The “tax” increases over time if a borrower fails to improve his credit score, the study found. Bankrate estimates it could cost borrowers with a credit score of 620 or lower an average of roughly $17,000 over five years and more than $100,000 on average over 30 years.
Besides home loans, the other financial products included in the study are auto loans, home and auto insurance, credit cards, and personal loans.
Borrowers with low scores not only pay more, they’re also more likely to be rejected for credit, ending up “in a cycle of long-term debt,” the report said. “If interest rates stay higher for longer, the gap between what prime borrowers and subprime borrowers pay for financial products could widen even more over time.”
Banks justify the extra charges because folks with scores below 620 are considered high-risk. Lenders also maintain these borrowers usually take more time and effort to approve, since many need to submit additional documentation like bank records. And they argue that underwriting their applications tends to be more expensive.
Those costs are passed off to the borrower in terms of higher premiums and APRs, the report points out.
Fair or not, it’s a simple equation, the report says. “It’s a matter of risk, or creditors’ and coverage providers’ appetite for doing business with subprime customers. In their eyes: “The lower your credit score, the more likely you are to fall behind on debt or file a claim.”
Four percent of annual household income may seem like a small figure in relation to other bills, but it can be devastating.
“People can maybe feel that credit is a little bit abstract if they’re not exactly in that buying process for getting a new credit card, a personal loan, a mortgage,” Margaret Poe, head of consumer education at TransUnion, told researchers.
“But when you think about how all these different costs add up across, say, a year, and all the ways that you’re involved in the credit economy, it’s not surprising.”
To estimate costs for its study, BankRate analyzed rates for full-coverage auto insurance, home insurance, and total accumulated interest. The premium and debt amounts in the calculations were based on national average data from Bankrate, Experian, and FICO.
