Subprime Mortgage

Subprime Mortgage Definition

Subprime Mortgage is the 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 on the higher side. As a result, the lender is able to recover a maximum amount at the beginning of the loan.

Types of Subprime Mortgages

Subprime mortgages vary depending on their characteristics like repayment plan and the interest rate. 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 as compared to a standard or prime mortgage which has a repayment period of 30 years. The longer repayment period enables the borrower to make lower monthly instalments and repay the loan in the long-time given.

The lender is happy to lend at a higher rate for a longer period since it not only guarantees the repayment of the mortgage but also an increased return for the actual amount that was initially borrowed.

Example

John is a college pass out and has just landed with a job; he has no prior credit history. He decides to own a home but has limited funds. He requires a loan to purchase his dream. 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 which bears a high interest.

#2 – Adjusted Rate Mortgage Loan (ARM)

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

Example

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.

#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 to be problematic for the borrower since the monthly instalments 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 reason and can result in default.

Example

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

Subprime Mortgage Crisis

The Subprime Crisis of 2008 had lost lasting impact on the global economy with banks bearing the brunt of the defaulted payments on subprime mortgages. This lead to the recession across the globe since all the market participants was 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 as the ‘Housing bubble’ which was highlighted by many economists across the world which focused on the dark side of the mortgage-backed securities being traded.

The subprime mortgages were doing well until 2006 when the mortgaged properties started falling. This happened when the interest rates were spiking during that period. The borrowers could neither sell their property nor could they refinance their mortgage, moreover they could not bear the rising instalments. Hence, they began to default. This led to mortgage-backed securities to plunge in value and resulted in the financial crisis.

Advantages

• It allows individuals with weak or no credit history to obtain a loan at an interest rate 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.
• Results in an inflow of funds into the market since the monthly instalments paid by the borrower can be used by the banks for different activities, including lending and investing in businesses thereby making movements in the economy.

Disadvantages

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

Recommended Articles

This has been a guide to Subprime Mortgage and its definition. Here we discuss its types, advantages and disadvantages along with the subprime crisis that happened in 2008. You can learn more from the following articles –

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