The term “sub-prime” refers to borrowers who do not qualify for the lowest, or “prime” rate of interest on a loan. Therefore, sub-prime mortgages are a class of loans offered at a higher rate of interest to borrowers who are unable to qualify for lower-interest home loans from conventional sources.
The reasons why a home buyer would be unable to qualify for a conventional loan vary, but generally, it is because lending to the borrower is viewed as a risk due to 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 therefore, need a sub-prime mortgage.
The Pros and Cons of Sub-Prime Mortgages
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 also include a large balloon payment at maturity. The adjustable rate mortgage (ARM), which initially charges a 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 percent.
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 for the additional risk 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.
If you’re thinking about obtaining a sub-prime mortgage, first consider whether you can really afford the higher interest rate or if you would be better off improving your credit first and then applying for a more competitive mortgage rate.
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[...] whether the agencies failed to do enough research to be able to adequately rate the pools of subprime mortgages and other loans that underpinned the mortgage bond deals. In May, the SEC went as far as stating [...]
[...] they could sell the debt instead), and became more lenient in their lending standards. This is when subprime mortgages and balloon-payment mortgages became extremely popular, allowing individuals with questionable [...]
[...] According to the Federal Reserve, Wells Fargo, the nation’s fourth largest bank by assets, steered potential borrowers with credit scores that could have qualified them for prime rates into more expensive subprime loans. [...]