Understanding Subprime Mortgages

Real Estate

Subprime mortgages are designed for individuals with poor credit scores who are unable to secure conventional loans. However, these loans are notorious for their high interest rates and expensive repayment terms. Dragon Claws/Shutterstock

For many Americans, owning a home is considered the ultimate goal. Unfortunately, the housing market in the United States experienced a massive boom and bust in the early 2000s due to various factors within the complex financial system. One of the primary factors that contributed to this rise and fall was the use of subprime mortgages, which allowed individuals with unstable credit ratings to obtain home loans.

The practice of lending money to individuals with poor or limited credit history is referred to as subprime lending. It is important to note that the term “subprime” does not specifically refer to the interest rates attached to the loans, but rather to the borrower’s credit rating. Most subprime borrowers have a credit score below 620 on a scale of approximately 300 to 850 (or 900, depending on the scoring system used). During the housing boom, many individuals who could have qualified for traditional home loans instead opted for subprime mortgages due to aggressive tactics used by mortgage brokers, such as easy loan approvals or not fully explaining strict repayment terms.

The interest rates on subprime mortgages can vary greatly and are based on a variety of risk-based factors, including credit score, down payment amount, number and types of delinquencies on credit reports. In 2006, subprime mortgages accounted for approximately 20 percent of home loans [source: Federal Reserve]. While subprime mortgages provide individuals with poor credit the opportunity to purchase a home, they are more likely to default on payments which has had a significant impact on the U.S. housing market and economy. Lenders were also severely affected, with some being forced to close completely.

Predatory lending is another negative aspect of the subprime market. Lenders often target minorities by preying on their inexperience. They may overvalue properties, overstate income, or even lie about credit scores to set exorbitant interest rates. They also encourage frequent refinancing at high closing costs, which are then rolled into the loan.

This article will delve into examples of subprime mortgages to help individuals determine if it is a viable option for them.

Understanding the Specifics of Subprime Mortgages

Subprime mortgages come in various forms, but what is consistent across the board is higher interest rates than the prime rate set by the Federal Reserve. The prime rate is what lenders charge individuals with good credit ratings.

Subprime loans often come with adjustable-rate mortgages (ARMs), which offer low initial monthly payments and interest rates that last for two to three years. After this period, the rate is adjusted every six to 12 months, potentially leading to a 50% or higher increase in payments. If you come across a 2/28 or 3/27 ARM, the first number indicates the number of years at the initial rate, and the second number indicates the number of years during which the rate can fluctuate.

Subprime ARMs may also offer interest-only options, where payments go towards the interest only during the initial period. For example, a 2/28 interest-only ARM allows you to pay only the interest for two years at a lower set rate, after which the loan is recalculated with a new rate over the remaining 28 years.

According to Investopedia, the increase in monthly payments on a 2/28 interest-only subprime ARM can be significant compared to a fixed-rate 30-year mortgage. Refinancing after the initial period may be challenging due to declining property values. Subprime loans often have prepayment penalties and balloon payments.

Other factors besides credit scores can also make a loan subprime, such as a borrower’s inability to provide proof of income or assets or borrowing an unusually large portion of their income.

However, not all is lost in the world of subprime lending. NeighborWorks America is a nonprofit organization that trains foreclosure counselors to help borrowers and inform communities of their options. The organization aims to address the lack of communication between subprime lenders and their clients, which often leads to foreclosure.

The subprime mortgage crisis was caused by a significant increase in defaults and foreclosures on subprime mortgages, which began in 2006. By July 2008, one in every five subprime mortgages were delinquent, with 29 percent of ARMs seriously delinquent. This resulted in $7.4 trillion in stock market paper losses and $3.4 billion in real estate wealth being wiped out.

Several factors contributed to the subprime mortgage crisis. Many mortgage brokers directed their clients toward loans that they could not afford, resulting in an industry that was not directly accountable for bad loans. Mortgage brokers did not face any penalty when a loan they drafted defaulted, leading to a lack of incentive to turn down applicants in this commission-based industry.

The unemployment rate was another factor leading to the crisis, with midwestern states hit hard by auto industry layoffs ranking among the highest in foreclosures. Many people were counting on refinancing to make their loans affordable, but slowing appreciation rates in the housing market made it difficult or impossible. Once the introductory period on the subprime loans ran out, the new payments were more than many could handle.

Borrowers also bear some responsibility for the crisis. Many did not read the fine print of their loan terms or took too big of a risk on a loan that they could not afford to pay back.

The subprime crisis also had an ugly facet, with claims that many lenders exploited minorities in the pursuit of profits. Black and Hispanic borrowers were more likely to have a subprime loan, with a 36 percent difference between Black and white borrowers in 2006. The Home Mortgage Disclosure Act of 1975 made it mandatory for lenders to maintain and disclose data in relation to their loans, revealing wild variations in HMDA numbers across racial lines. In addition, a 2006 study found that when credit risk was equal, Blacks were still more likely to receive a higher rate than whites.

This article was originally published on December 4, 2007.

FAQ on Subprime Mortgages

What is the subprime mortgage crisis?

The subprime mortgage crisis arose when banks had to meet the demand for mortgage-backed securities (MBS) and consequently offered mortgages that were risky, given the inability of owners to keep up with payments. This led to a decline in home prices, an increase in foreclosures and ultimately the failure of mortgage-backed securities.

Are subprime mortgages making a comeback?

The newer version of subprime mortgages is known as “non-prime” mortgages. They are gaining popularity again but require stricter proof of payment.

Do subprime loans negatively affect your credit?

Any loan can cause harm to a credit score if the person has a loan-to-income ratio that is too high or misses payments.

Who is responsible for the subprime mortgage crisis?

The blame for the subprime mortgage crisis can be attributed to multiple bad actors, including predatory lenders (those who offered mortgages to people who could not repay them), credit rating organizations that turned a blind eye, and the mortgage-backed security industry at large.

Why is subprime lending harmful?

These loans are given to people who are less likely to be able to make payments. Consequently, the lender offers a higher interest rate, making the loan even more difficult to repay.

More Information Available

Related Articles

• How Banks Work
• How Credit Reports Work
• How Credit Scores Work
• How the Fed Works
• How Mortgages Work

Sources­

• Kroszner, Randall S. “At the Consumer Bankers Association 2007 Fair Lending Conference.” federalreserve.gov, November 5, 2007. http://www.federalreserve.gov/pubs/bulletin/2007/pdf/hmda06draft.pdf
• Lewis, Holden. “Fixing subprime mortgage lending isn’t easy.” bankrate.com, April 18, 2007. http://www.bankrate.com/brm/news/mortgages/20070308_Fed_guidance_loan_rules_a1.asp
• “The NAACP Filed an Historic Lawsuit Against Mortgage Lenders Alleging Racial Discrimination.” naacp.org. July 17, 2007. http://www.naacp.org/get-involved/activism/alerts/ 110aa-2007-7-11/index.htm
• Shaw, Annie. “Are you subprime?” MSN Money, October 7, 2007. http://money.uk.msn.com/guides/dealing-with-debt/article.aspx?cp-documentid=6292746
• Schlomer, Li, Ernst, and Keest. “Losing Ground: Foreclosures in the Subprime Market and Their Cost to Homeowners.” Center for Responsible Lending, 2006. http://www.responsiblelending.org/pdfs/Fclosure-exec-summary-standalone.pdf
• “Subprime Mortgages.” bankrate.com, May 1, 2006. http://www.bankrate.com/brm/green/mtg/basics2-4a.asp?caret=8

FAQ

1. What is a subprime mortgage?

A subprime mortgage is a type of loan that is offered to borrowers with poor credit or limited credit history. These mortgages typically have higher interest rates and more lenient qualification requirements than traditional mortgages.

2. How do subprime mortgages work?

Subprime mortgages work by allowing borrowers with poor credit to purchase a home or refinance an existing mortgage. These loans typically have higher interest rates, as lenders consider borrowers with poor credit to be a higher risk. Additionally, subprime mortgages often come with fees and penalties for late payments or defaults.

3. Who is eligible for a subprime mortgage?

Borrowers with poor credit or limited credit history are typically eligible for subprime mortgages. Lenders may also consider factors such as income and employment history when determining eligibility.

4. What are the risks of taking out a subprime mortgage?

The risks of taking out a subprime mortgage include higher interest rates, fees and penalties for late payments or defaults, and the possibility of foreclosure if the borrower is unable to make payments.

5. How do subprime mortgages affect the housing market?

Subprime mortgages can have a significant impact on the housing market. During the early 2000s, the widespread availability of subprime mortgages contributed to a housing bubble that ultimately led to the financial crisis of 2008.

6. What is a subprime mortgage crisis?

The subprime mortgage crisis was a financial crisis that occurred between 2007 and 2010. It was caused by the widespread issuance of risky subprime mortgages, which ultimately led to a collapse of the housing market and a global financial crisis.

7. What caused the subprime mortgage crisis?

The subprime mortgage crisis was caused by a number of factors, including the widespread issuance of risky subprime mortgages, the use of complex financial instruments, and lax regulation of the financial industry.

8. How did the subprime mortgage crisis affect the global economy?

The subprime mortgage crisis had a significant impact on the global economy. It led to a global financial crisis, which caused widespread job losses, bankruptcies, and economic downturns in many countries around the world.

9. What were the consequences of the subprime mortgage crisis?

The consequences of the subprime mortgage crisis included a collapse of the housing market, a global financial crisis, widespread job losses, bankruptcies, and economic downturns in many countries around the world.

10. What steps were taken to prevent another subprime mortgage crisis?

Following the subprime mortgage crisis, a number of steps were taken to prevent another crisis from occurring. These included increased regulation of the financial industry, stricter lending standards, and increased oversight of complex financial instruments.

11. Are subprime mortgages still available?

Subprime mortgages are still available, although they are less common than they were before the subprime mortgage crisis. Lenders typically require higher credit scores and more stringent qualifications for subprime mortgages today.

12. Should I consider a subprime mortgage?

Whether or not to consider a subprime mortgage depends on your individual financial situation. If you have poor credit, a subprime mortgage may be one of your only options for purchasing a home or refinancing an existing mortgage. However, it is important to carefully consider the risks and potential consequences before taking out any type of loan.