Subprime Mortgages, Their Types, and Impact on the Economy

How Subprime Mortgages Helped Cause a Crisis

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Table of Contents
Table of Contents

A subprime mortgage is a housing loan granted to borrowers with impaired credit history or even no credit history. Their credit scores don't allow them to get a conventional mortgage.

Key Takeaways

  • Banks may offer home loans to high-risk borrowers in the form of subprime mortgages, which compensate for risk with extra costs and high interest.
  • Subprime mortgages use a number of sneaky tactics to draw borrowers. They may seem enticing at first, but they end up costing much more in the long run.
  • A series of investment products built upon subprime mortgages, along with falling house prices, together caused the 2008 financial crisis.

What Are Subprime Mortgages?

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 or bankrupt, or they have low credit scores and/or low income. Specifically, they've been delinquent on their payments, with two or more 30-day delinquencies in the past year. The lender had to write off or write-down their loan, or there has been a judgment against them in the last two years. They are subprime borrowers if they have gone bankrupt in the last five years. Their annual income is less than half of the total yearly principal plus 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. These mortgages might have higher interest rates, higher closing costs, or higher down payments required.

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 their rates 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 that they will either refinance or sell their house before the principal needs to be repaid. That's a very dangerous assumption, because that's when the monthly payment increases. The borrower usually can't afford the higher payment. If the value of the home drops, then they can't qualify for a refinancing. They might not be able to sell the house either. In that 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 it did 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 more is added to the principal. In other words, the principal grows each month.
  • Ultra-long fixed-rate loans extend 40 or 50 years, considerably longer than the conventional 30-year mortgage.
  • Balloon loans allow low monthly payments but require 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.

Economic Impact

Subprime mortgages were one of the causes of the 2008 financial crisis. Hedge funds found that they could make lots of money buying and selling mortgage-backed securities, which are derivatives based on the value of the underlying mortgages. They became popular when the financial services industry started bundling the subprime mortgages with high-quality conventional mortgages.

Banks divided these bundles into different components, called "tranches." They put all of 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 all off, in addition to selling the risky and misleading tranches, banks sold insurance against any default, called "credit default swaps."

The popularity of mortgage-backed securities meant that banks needed 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.

An Unfortunate Collision of Events

All went well until housing prices started to fall in 2006. Such a decline had rarely happened in U.S. history, and unfortunately, that time it occurred around the same time many borrowers found their interest rates spiking in the third to the fifth years of the exotic mortgages.

Since homes became worth less than the balances of the mortgages, their owners couldn't refinance or sell. When they started to default, the owners of the mortgage-backed securities realized that their derivatives weren't worth what they had paid for them. When they tried to collect their insurance, the issuer, American Investment Group AIG, almost went bankrupt, leading in part to the 2008 financial crisis.