Subprime Mortgage

A subprime mortgage is a loan against property offered to those borrowers with a weak credit history or no credit history. Since the risk of recovering the borrowed amount is high, the interest rate charged on such mortgages is higher. As a result, the lender can recover a maximum amount at the beginning of the loan.

In today’s world, such kind of mortgage is uncommon because the lenders have become cautious because of the high risk that these loans carry. There are many rules and regulations to prevent such a practice since the extensive risk affect the global market in a negative way. Lenders should properly analyse the borrower’s credit condition before giving loans.

• A subprime mortgage is a loan secured by real estate given to applicants with poor or no credit histories.
• These mortgages often have higher interest rates and fees than prime mortgages, meaning the borrowers have higher monthly payments and greater risk of default.
• There are three types of subprime mortgages, including fixed interest rates, ARM loans, and interest-only loans.
• Because the banks can use the monthly payments made by the borrower for a variety of purposes, such as lending and investing in enterprises, this causes a flow of money into the market and causes economic movements.

A subprime mortgage is a loan extended to borrowers who do not have a good credit history and, thus, may not be able to pay back the installments on time. For example, they might have a very limited income or unstable employment or already have a lot of debt in the market.

It is very risky to give loans to such borrowers due to which subprime mortgage lenders charge high interest from them and maintain strick credit rules and conditions.

This kind of loan gained a lot of importance in the market in the early 2000s. Banks and financial instututions extended credit to people without strong credit history, who would not have qualified for loan otherwise. However, this practice led to a huge crash in the housing loan market of US in 2008, due to a wave of default. This brought a consciousness at the global level regarding the negative consequences of lending money in this manner. Now, financial institutions maintain some strict rule while lending so that such unpleasant market conditions can be avoided.

There are many types of subprime loans that are floating in the market, as given below:

Subprime mortgages vary depending on their repayment plan and interest rate characteristics. Owing to the risk involved in these mortgages, the lending bank can choose to offer a repayment plan that works in their best interest. The mortgages can range from 30-50 years, depending on the amount borrowed and the capacity of the borrower to repay.

#1 - Fixed Interest Rate

The fixed interest rate mortgage is offered at a higher rate of interest with a repayment period of up to 40 – 50 years compared to a standard or prime mortgage with a repayment period of 30 years. The longer repayment period enables the borrower to make lower monthly installments and repay the loan in the long-time given.

The subprime mortgage lenders are happy to lend at a higher rate for a longer period since it guarantees the repayment of the mortgage and an increased return for the actual amount that was initially borrowed.

#2 - Adjusted Rate Mortgage Loan (ARM)

An adjusted-rate mortgage loan, as the name suggests, has its subprime mortgage rates adjusted during the tenure of the loan. It is initiated with a fixed rate and later switched to a floating rate.

#3 - Interest Only Loan

An interest-only loan requires the borrower to pay only the interest for the initial few years of the loan. In this case, the borrowers assume they can fetch a refinance for their property or sell the property before the principal payment starts. This can prove problematic for the borrower since the monthly installments will increase, and the borrower is usually unable to bear the additional burden. Also, if the value of the mortgaged property falls, they cannot qualify for a refinance. They will not have an option to sell the property due to this, resulting in default.

Let us look at a few examples related to this type of loans which will give us a better understanding of the concept.

Example #1

Let's take John from the above example; after taking an interest-only loan, he wishes to refinance his mortgage without looking at the property's current market price, which has plunged. As a result, his monthly installments will increase, whereas the value of his property has taken a dip.

Example #2

John is a college pass-out and has just landed a job; he has no prior credit history. He decides to own a home but has limited funds and requires a loan to purchase his dream home. In this case, he can approach a bank for a mortgage loan against the property he wishes to own. The bank can offer a fixed interest rate loan that bears a high interest.

Example#3

A 30-year mortgage which is 2 / 28 ARM, means the first two years will bear a fixed interest rate, and the remaining 28 years will bear a floating interest rate. Similarly, a 3 / 28 ARM means the first three years will bear a fixed interest rate, and the remaining will bear a floating interest rate.

The Subprime Crisis of 2008 had lost a lasting impact on the global economy, with banks bearing the brunt of the defaulted payments on subprime mortgage market. This led to the globe's recession since all the market participants were impacted directly or indirectly, thereby creating a major impact on business across industries.

Almost 9 million jobs were lost due to the subprime crisis between 2008 and 2009. The subprime crisis is also termed the 'Housing Bubble' highlighted by many economists worldwide, focusing on the dark side of the traded mortgage-backed securities.

The subprime mortgage companies did well until 2006, when the mortgaged properties fell. This happened when the interest rates were spiking during that period. As a result, the borrowers could neither sell their property nor refinance their mortgage; moreover, they could not bear the rising installments. Hence, they began to default. This led mortgage-backed securities to plunge in value, resulting in a financial crisis.

Let us look at the different advantages of this subprime loans.

• It allows individuals with weak or no credit history to obtain a loan at a subprime mortgage rates that is higher than the market rate.
• Banks and financial institutions can benefit by providing subprime mortgages since it gives higher returns than prime mortgages.
• This results in an inflow of funds into the market since the monthly installments paid by the borrower can be used by the banks for different activities, including lending and investing in businesses, thereby making economic movements.

Thus, the above points gives us knowledge about the various benefits that the lenders and the borrowers get from such kind of loans.

Along with advantages, it is also necessary to understand the disadvantages of this type of loan so that the financial institutions can take informed decisions before lending to a borrower.

• The risk to reward ratio for subprime mortgages is very high compared to prime mortgages. The higher side is the probability of a subprime mortgage borrower missing a payment or payments or default making any payments.
• The subprime mortgage market crisis that shook the world was due to the excessive lending of such mortgages. The hedge funds that traded in buying and selling these mortgage-backed securities resulted in the crisis.
• If the borrower defaults to make the payments, the subprime mortgage companies has to bear the losses, which creates a rippling effect in the economy.

The disadvantages also play a huge role in making a decision whether such subprime loans can be extended to the borrowers or not.

The above are the two types of home loans which have different risk levels as well as variation in the credit rating of borrowers. However, let us look at the differences between the two.

• The former takes place when the borrowers are not having a good credit rating and the latter happens when the borrower has a very good credit history.
• The former signifies that the loan given to them will have a lot of risk since the borrower may not have enough money to pay the installments, whereas the latter carries lesser risk since there is very less possibility of the borrower defaulting on the loan.
• Prime borrowers usually get a good deal while borrowing in the form of low interest rate and favourable terms which is not given to subprime borrowers due to their low creditworthiness.

It can be summarized that both prime and subprime borrowers take loans but vary in creditworthiness and risk levels. Based on these facts they get approval for interest rates, and other terms and conditions while applying for a loan.

This has been a guide to what is Subprime Mortgage. We explain the crisis of 2008 along with examples, differences with prime mortgage & advantages. You can learn more from the following articles –

• Subprime Loans
• Delinquency Rate
• Collateralized Debt Obligation
• Asset Backed Securities