What Is A Subprime Mortgage?
The recent financial crisis has brought the concept of the subprime mortgage to the forefront of the lending world. Nearly every news program has a report on the continuing subprime problem. It is easy to see that a subprime mortgage is bad, or at least has turned out badly in the current economic situation. People are losing their homes, banks are foreclosing, and investors that bought securities based on these loans are losing money. However, few of these news reports remind the average viewer just what a subprime mortgage loan is.
Most people know that a mortgage is a type of real estate loan. The term is typically associated with buying a home. Mortgages are money loans typically lasting 30 years, although the period can be more or less than that. The interest rate paid by the borrower for the use of the mortgage loan money can be a fixed rate or an adjustable rate. Each month, the borrower sends the lender a payment usually consisting of both a principal part and an interest part. These payments continue until the entire amount of the loan, including the interest, has been fully repaid.
The confusion with subprime mortgages is the term "subprime." One might assume that such a loan is made at an interest rate that is below the prime lending rate. However, the opposite can be true. The term "subprime" refers to the quality of the borrower's credit rating, not to the interest rate itself.
A prime borrower has an excellent credit rating and a history of financial responsibility. A subprime borrower typically has a bad or poor credit score, may be behind on certain payments or bills, and carries more risk for the lender. Therefore lenders often assign higher interest rates to subprime mortgages to offset the risk. That rate might even be above the prime lending rate. Therefore a "sub-prime" borrower might have to pay a "super-prime" interest rate.
Subprime mortgages carry a higher risk of non-payment, called default, because they are given to borrowers who may already have financial difficulties. If the borrower continues to make the payments on time until the loan is repaid, there is no problem. The borrower's credit score might even increase. If the borrower starts missing payments or even stops paying, then the lender must foreclose on the property. This allows the bank to resell the property to recover its losses.
The subprime mortgage crisis occurred for many reasons too numerous to explain here. One of the primary ones seems to be that unscrupulous lenders with lots of worthless subprime mortgages repackaged them as good investments and sold them to unknowing investors worldwide.
The term "subprime" in subprime mortgages refers to the quality of the borrower's credit, not to the interest rate. Some subprime loans may have helped certain people who might not otherwise have been able to obtain loans. However, the financial crisis precipitated by these loans has soured the market for true subprime lenders.