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Subprime mortgages, also known as subprime home loans or non-qualified mortgages, are loans granted to individuals with poor credit scores or limited credit histories. These “subprime borrowers” are considered high-risk due to their lower creditworthiness.
Due to the higher risk associated with lending to such individuals, lenders typically charge higher mortgage rates on subprime mortgages than conventional or “prime” mortgages offered to borrowers with better credit histories.
Key characteristics of subprime mortgages include:
Higher Interest Rates: Lenders charge higher interest rates on subprime mortgages than prime mortgages to compensate for the higher risk of default.
Adjustable-Rate Mortgages (ARMs): Many subprime mortgages are offered as adjustable-rate mortgages, where the interest rate may start low but can increase significantly over time. This can lead to substantially higher monthly payments for the borrower.
Higher Fees and Penalties: Subprime mortgages may have higher fees, including origination fees and steeper penalties for late payments or defaults.
Increased Risk of Default: Due to the higher costs and often unstable nature of the interest rates, borrowers of subprime mortgages have a higher likelihood of defaulting on their loans.
What was the Subprime Mortgage Meltdown?
The subprime mortgage meltdown was pivotal in the global financial crisis of 2007-2008. Up to this period, banks and other financial institutions had lowered lending standards, offering subprime mortgages to individuals with poor credit histories and unstable incomes. The boom in subprime lending was fueled by a robust housing market and the belief that property values would continue to rise indefinitely.
However, the situation drastically changed as housing prices plummeted in 2006 and 2007. The decline in property values left many subprime borrowers with mortgages larger than the value of their homes. Simultaneously, the adjustable interest rates on many subprime mortgages reset to much higher levels, dramatically increasing monthly payments for borrowers.
This led to a surge in defaults and foreclosures, as many borrowers could not refinance or sell their homes at a loss. The crisis was exacerbated by the widespread securitization of subprime mortgages, meaning that the impact of defaults and foreclosures spread throughout the financial system, affecting many financial institutions and investors.
In response, governments and financial regulators around the world implemented significant reforms. Since then, the housing market and the broader financial system have shown signs of recovery, with more robust lending standards and risk assessment practices in place to prevent a repeat of the subprime mortgage crisis.
Subprime Mortgage Example
Subprime mortgages are less common today than before the 2007-2008 financial crisis. However, they could still occur with proper oversight. Let’s consider an example using a subprime borrower named John.
John has a credit score of 560, which is considered subprime. He has a high debt-to-income ratio due to outstanding credit card debts and a recent bankruptcy filing two years ago.
After applying for a home loan with several lenders, one offers John a subprime, adjustable-rate mortgage (ARM). It starts with a relatively low introductory interest rate, but the rate is set to adjust after two years, which can lead to substantial increases, potentially making the monthly payments unaffordable for John in the future.
There are additional loan terms that will put pressure on John’s finances. The interest rate is significantly higher than the average rate offered to borrowers with good credit. Finally, while the down payment requirement is lower than usual to make it more accessible for John, the loan comes with higher origination fees and penalties for late payments.
In this example, the subprime mortgage allows John to purchase a home despite his poor credit history, but it also poses significant risks due to the higher interest rate, potential for rate increases and additional fees. Even if John is cautious, there are forces outside of his control that could make the loan unaffordable for him in the future.
» MORE: See today’s refinance rates
Prime vs. Subprime Loans
Prime and subprime mortgages differ primarily in the creditworthiness of the borrowers they are designed for and the terms of the loans. Their primary differences include:
Credit Score and Financial Stability
Prime borrowers have higher credit scores and more stable financial histories than subprime borrowers. Prime mortgages are typically offered to borrowers with good to excellent credit scores, typically above 670, while the credit scores of subprime borrowers are usually below 620.
Interest Rates and Loan Terms
Prime mortgages offer more favorable terms, including lower interest rates and more stable loan structures. ARMs are common in subprime loans, which may start with a low introductory rate but can increase substantially over time.
Fees and Penalties
Prime mortgages have lower origination fees and fewer penalties for late payments or refinancing. There’s also more flexibility in terms of loan features.
Risk of Default
The risk of default is higher with subprime mortgages due to the borrowers’ precarious financial standing and the loans’ terms.
The Bottom Line
Due to the increased education of both borrowers and lenders and enhanced regulations, subprime mortgages are mostly a thing of the past. There is still a small market for subprime mortgages, but they are recommended less than they were many years ago, and they are monitored more closely than other loan products.