What Is a Subprime Mortgage?

Tamsen Butler
money

Recently, many people unfamiliar with the term found themselves asking "what is a subprime mortgage"? This rarely discussed segment of the home loan industry suddenly began making international headline news as it took the blame for what may potentially turn out to be the worst mortgage industry meltdown in history.

Definition of a Subprime Mortgage

The term subprime mortgage is used to describe home loans made to individuals with less than stellar credit history. Creditworthiness is based on an individual's credit score, which can range from 300 to 900.

Many factors impact an individual's credit score. Those with habitual patterns of late payments and other credit problems typically have poor credit scores. The dividing line between standard and subprime mortgages is around 620, with credit scores at or below that level falling into the subprime lending category.

Individuals with low credit scores are not the only consumers of subprime loans. Those who have difficulty providing definitive proof of income - such as self employed people - often have to go with subprime loans when financing real estate, regardless of their credit scores.

Interest Rates and Subprime Loans

Because those with lower credit scores are continued greater lending risks, interest rates on subprime loans are higher than those for traditional mortgage loans. A majority of subprime home loans are adjustable rate mortgages (ARM), meaning that interest rates adjust up or down depending on a variety of economic factors.

ARM loans are risky for lenders and borrowers alike. The mortgage lender assumes greater risk of default by making loans to individuals in the subprime market segment. Borrowers assume the risk of dealing with increasing home loan payments resulting from changing economic conditions.

Until 2007, mortgage rates had been low and stable since the early 1990s. Becaue of this, many people didn't really consider the consequences of significant ARM adjustments when purchasing homes. However, when interest rates started to increase many homeowners found themselves facing skyrocketing mortgage payments they never expected.

Factors Leading to the Subprime Mortgage Crisis

Declining Property Values

Many people accept ARM loans intending to improve their credit sufficiently to be able to refinance to a traditional fixed rate mortgage prior to the first interest rate adjustment. However, during 2007 property values started to decline, with market conditions "correcting" for what has been described as the real estate pricing "bubble". Many homeowners needing to refinance to avoid steeply increasing mortgage payments discovered that their homes no longer appraised high enough to qualify for a refinance.

Increasing Foreclosure Rates

As people facing increasing ARM payments felt the consequences of being unable to refinance their homes, foreclosure rates began to climb drastically. As large numbers of homes started going into foreclosure property values dipped even further. The real estate market became flooded with supply even as demand decreased further due to continued interest rate increases.

Crisis for Lenders

As the foreclosure rates on subprime mortgages continued to rise, the solvency of lenders specializing in subprime mortgages began to decline. An enormous number of private banks and other lending institutions shut down between July and October of 2007 as a direct result of excessive default rates.

Even major players in the financial markets who were able to remain afloat experienced significant losses and took a major hit in terms of stock prices. The impact was not limited to the mortgage and real estate industries. Financial markets around the world were impacted, and the effects will be felt for decades to come.

Predatory Lending Practices

During the ten years between 1996 and 2006, the total percentage of new mortgages falling in the subprime category doubled, meaning that a larger portion of loans made were high risk loans. As these loans started to go into default, the lenders took huge financial losses in a major market segment.

There are claims that predatory lenders steered consumers with poor credit in the direction of taking out expensive mortgage loans on properties that were beyond their financial means. It has even been suggested that many homes were financed beyond their true values as a result of inflated real estate appraisals conducted on behalf of predatory lenders.

What Is a Subprime Mortgage Now?

The mortgage industry as it existed prior to 2007 really doesn't exist anymore. As of October of 2007, the economy is reeling from a staggering $200 billion of subprime mortgage defaults. There are serious questions regarding the future of subprime lending. The regulatory environment in which mortgage lenders operate is likely to change significantly in the future.

Written by Mary Gormandy White

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What Is a Subprime Mortgage?