Subprime Mortgages, Their Types, and Impact on the Economy
How Subprime Mortgages Helped Cause a Crisis
A subprime mortgage is a housing loan that's granted to borrowers with impaired credit history. Often, they have no credit history whatsoever. Their credit scores don't allow them to get a conventional mortgage.
What Is a Subprime Mortgage?
Subprime mortgages are loans that banks deliberately grant to subprime borrowers. They don't include loans that develop credit problems after acquisition, subprime loans that are later upgraded to prime loans, or government-insured loans.
According to the Federal Deposit Insurance Corporation (FDIC), subprime borrowers have been delinquent, bankrupt, or have low credit scores and/or low income. Specifically, they've been delinquent on their payment with two or more 30-day delinquencies in the past year. The lender had to write-off or write-down the loan, or there has been a judgment against them in the last two years. They're subprime if they have gone bankrupt in the last five years. Their annual income is less than half of the total yearly principal + interest payments on the loan.
Subprime borrowers typically have low credit scores, such as a FICO of 660 or below.
Subprime loans have a higher risk of default than loans to prime borrowers. Banks charge higher fees to compensate them for the additional risk. They may have higher interest rates, greater closing costs, or require more of a down payment.
A high-cost loan must be reported to the FDIC if its annual percentage rate (APR) is more than three percentage points greater than the yield on a similar Treasury bond. It should also be reported if the closing costs are more than 8% of the loan amount.
Types of Subprime Loans
In the 2000s, banks offered all types of exotic loans to subprime borrowers. These loans were cheap in the beginning but made profits for the banks later on. Most had low "teaser" rates for the first year or two. Many borrowers didn't realize that rate rose dramatically after that. Others thought they could sell the house or refinance before then. Most of these loans are no longer as widely available as they were before the subprime mortgage crisis.
Here are examples of the most popular subprime mortgages:
- An interest-only loan doesn't require that any of the principal be paid for the first several years of the loan. That makes it easier to afford than any other loan. Most borrowers assume they will either refinance or sell their house before the principal needs to be repaid. That's very dangerous because that's when the monthly payment increases. They usually can't afford the higher payment. If the value of the home drops, then they can't qualify for a refinance. They can’t sell the house either. In this case, they are forced to default because they can't make the higher payment.
- Option adjustable rate mortgage loans allowed borrowers to choose how much to pay each month. The small payment meant the rest was added to your principal. After five years, the option disappears and the loan costs even more than in the beginning.
- Negative amortization loans never pay off the principal. In fact, the interest payments are so low that each month, the debt grows larger as it was added to the principal. In other words, the principal grew each month.
- Ultra-long fixed-rate loans extend 40 or 50 years, instead of the conventional 30-year mortgage.
- Balloon loans allow low monthly payments but required a big payment after five to seven years to pay off the rest of the loan.
- No-money-down loans allow the borrower to take out a loan for the down payment.
Subprime mortgages were one of the causes of the subprime mortgage crisis. Hedge funds found they could make lots of money buying and selling mortgage-backed securities. These are derivatives that are based on the value of the underlying mortgages. They became popular when the financial services started bundling the subprime mortgages with high-quality conventional mortgages.
Banks divided these bundles into different components, called tranches. They put all the low-interest payments from the first three years of the subprime mortgages in with the low-interest payments of conventional loans. The high-interest payments were bundled into tranches that appeared to be riskier because they were high yield. To top it off, they sold insurance against any default, called credit default swaps.
The popularity of mortgage-backed securities meant banks needed more and more actual mortgages to feed the demand. Banks created these exotic mortgages just to get more business booked. They bundled the mortgages and sold them to the hedge fund traders.
All went well until housing prices started to fall in 2006. This had rarely happened in U.S. history. Unfortunately, it occurred around the same time many borrowers found their interest rates spiking in the third to fifth year of the exotic mortgage.
Since their house was now worth less than the mortgage, they couldn't refinance or sell the home. When they started to default, the owners of the mortgage-backed securities realized their derivatives weren't worth what they paid for. When they tried to collect their insurance, the issuer, American Investment Group AIG, almost went bankrupt. This led to the 2008 financial crisis.