The term Sub-Prime might suggest an interest rate that is below the prime rate of interest. However, the opposite is true. Sub-prime mortgage loans are a class of loans that are offered at a higher rate of interest than the prime rate, to borrowers who are unable to qualify for lower-interest loans from conventional sources.
The reasons why a home buyer would be unable to qualify for a conventional loan vary, but most commonly, the borrower is viewed as a risk because of a poor credit rating, or an inability to prove income. For example, someone with a credit rating below 620, a spotty work history, and/or a lack of tangible assets would be considered a risk, and would most likely be unable to qualify for a prime rate loan through a traditional lender.
Such a buyer would most likely resort to financing their home purchase through the higher-interest sub-prime loan. While these types of loans have increased opportunities for home ownership to millions of households who otherwise would not have qualified for a loan, the sub-prime loan also carries a cost, quite literally. Lenders calculate the terms of the loan through a process called risk-based pricing: the worse your credit, the more you are likely to pay in higher interest rates and fees. They may also include penalties for early repayment, making it difficult for the borrower to refinance the loan at a more equitable rate. Some loans include large balloon payments at maturity. The adjustable rate mortage (ARM), which initially charges an artificially lowered introductory fixed rate, eventually converts to a floating variable rate which can increase monthly payments sharply and suddenly, sometimes by as much as 50%.
From 2004-2006, many lenders were more liberal in approving these types of loans. The loans were viewed as profitable because lenders were able to charge interest rates above the prime rate in order to compensate themselves for the additional risks that they assumed. However, once interest rates rose again, many borrowers found themselves unable to meet their increased monthly payments and their properties went into foreclosure. The increased foreclosure rate forced many lenders into extreme financial difficulty, and sometimes even bankruptcy.
