Updated July 11, 2023
Definition of Subprime Mortgage
The term “subprime mortgage” refers to loans granted to borrowers with poor credit scores of less than 600. These borrowers fail to qualify for conventional mortgages because of their weak credit scores.
The term “subprime” refers to the fact that these borrowers exhibit a higher propensity to default on loan repayment than those having higher credit scores. In short, a subprime mortgage involves a large credit risk for the lender.
How Does Subprime Mortgage Work?
The term “subprime” refers to a borrower’s financial condition and credit history, which forms the basis for the interest rate charged for the extended loan. The lender grants a prime borrower a mortgage at a lower rate due to their excellent credit history. At the same time, they charge higher interest rates and offer less-favorable terms to a subprime borrower because of their poor credit history. In the case of a subprime mortgage, the interest rate is determined based on four factors – credit score, size of the down payment, and number & types of payment delinquencies stated on the borrower’s credit report.
Example of Subprime Mortgage
Before the financial crisis of 2007-08, many banks and financial institutions began extending mortgages to individuals with credit ratings below 600. Lenders frequently offer these mortgages without requiring any down payment or proof of income. The borrowers could state their annual earnings to be $150,000, but they didn’t need to provide any documents to validate the claim.
These borrowers later found themselves in trouble once the housing market started declining, resulting in lower home values than the borrowed mortgage money. Many of these borrowers defaulted as the interest rates that started low began to balloon over time, making it extremely difficult for them to pay off the principal part of the mortgage. The housing market crash witnessed in 2008 was largely due to the widespread defaults on subprime mortgages.
Types of Subprime Mortgage
Three main subprime mortgage types are fixed-interest, adjustable-rate, and interest-only mortgages.
1. Fixed-Interest Mortgages
These mortgages usually offer an extended 40- or 50-year term compared to the standard 30-year for conventional mortgages. This extended loan period results in lower monthly payments for the borrowers. Nevertheless, these loans offer a significantly higher interest rate.
2. Adjustable-Rate Mortgages
These loans typically start with a fixed interest rate and then switch to a floating one. In these loans, the monthly payments for the borrowers are usually lower during the initial term. However, the payments increase significantly once the mortgages switch to a higher variable rate. The floating rate depends on an index (such as the secured overnight financing rate or SOFR) plus a margin.
3. Interest-Only Mortgages
In the initial few (5 to 10) years of the mortgage, the principal payments are postponed such that the borrowers only pay the interest. However, the borrowers can still make the principal payments during the moratorium period. Once the initial term is over, the borrowers must either start paying off the principal or refinance the mortgage.
Impact of Subprime Mortgage
The major downside of subprime mortgages is that these loans extend to people whose financial position indicates a higher propensity to default on loan repayment. The real problem begins when the subprime mortgage becomes an economy-wide phenomenon, as we witnessed during the housing market crash 2008. Once many borrowers default on their mortgages, the rate of housing foreclosures climbs sharply, and the lenders lose all their money. The impact of the last subprime mortgage crisis radiated throughout financial markets and economies worldwide, leading to a global recession.
The Interest Rate on Subprime Mortgage
Given the higher credit risk associated with subprime mortgages, lenders usually charge a higher interest rate than the prime lending rate. The interest rate on subprime mortgages depends on different factors – the amount of down payment, credit score, and reported delinquencies. In many cases, the interest rate is adjustable-rate such that the interest rate can potentially go up at specified points in time in the future.
Risks of Subprime Mortgage
The various risks associated with subprime mortgages are as follows:
- Higher interest rate: The high-interest rate accompanying a subprime mortgage significantly increases the borrower’s payout over the loan’s life.
- Larger down payment: Subprime mortgages usually require a higher down payment than conventional mortgages to offset the assumed risk. The down payment requirement can go up to 25% and above.
- Longer term: These loans are offered for an extended period to contain the value of monthly payments, but stretching out the loan duration amplifies the impact of higher interest rates.
Key Takeaways
Some of the key takeaways of the article are:
- Subprime mortgage refers to mortgages offered to borrowers with below-average credit scores, indicating a higher level of credit risk.
- The borrowers of subprime mortgages usually have credit scores of less than 600, accompanied by other negative information on their credit reports.
- The lenders charge higher interest rates for subprime mortgages to compensate for the risk of borrower default that they assume.
- The global crisis of 2008 was largely due to the proliferation of subprime mortgages offered to unqualified borrowers, eventually leading to a financial meltdown.
- Three main types of subprime mortgages are fixed-interest, adjustable-rate, and interest-only mortgages.
Conclusion
A subprime mortgage is the best option for borrowers lacking credit history or if it is blemished. Subprime lending indeed enhances the number of people owning a house, but it happens at a cost – higher chances of default, which is not a healthy sign. A default hurts not just the lender but also the borrower and his/ her credit score.
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