Subprime Loan

Refers to those loans that are given to people at a higher interest rate than a prime loan

Individuals who do not qualify for prime-rate loans are given subprime loans at a rate higher than prime.

Subprime loan

Traditional lenders have frequently turned down subprime customers due to low credit scores or other criteria that indicate they have a reasonable possibility of defaulting on debt repayment.

In March 2007, the value of subprime mortgages in the United States was projected to be $1.3 trillion, with approximately 7.5 million first-lien subprime mortgages outstanding.

Between 2004 and 2006, the share of subprime mortgages as a percentage of overall originations fluctuated from 18% to 21%, compared to less than 10% in 2001–2003 and 2007.

The boom in mortgage lending, including subprime lending, was also fueled by the rapid growth of non-bank independent mortgage originators.

They had a lesser market share (approximately 25% in 2002), accounting for over half of the rise in mortgage credit between 2003 and 2005.

In the third quarter of 2007, subprime ARMs accounted for 43% of all foreclosures in the United States but accounted for only 6.9% of all mortgages.

Percentage

By October 2007, over 16% of subprime adjustable-rate mortgages (ARMs) were either 90 days late or in foreclosure, roughly treble the rate in 2005. The delinquency rate had grown to 21% in January 2008, and it had risen to 25% in May 2008.

According to RealtyTrac, the total value of all outstanding residential mortgages due by U.S. households to acquire residence dwellings for no more than four families was US$9.9 trillion at the end of 2006 and US$10.6 trillion in mid-2008.

Lenders started foreclosure procedures on roughly 1.3 million houses in 2007, up 79% from 2006. This climbed by 115% from 2007 to 2.8 million in 2009.

How a Subprime Loan Works

When banks lend money to one another in the middle of the night to fulfill reserve requirements, they charge the prime rate based on the federal funds rate set by the Federal Open Market Committee (FOMC).

Card

Even though the Federal Reserve has no direct role in determining the prime rate, many banks base their premium rates on the FOMC's target level for the federal funds rate, which is the rate banks charge each other for short-term loans.

The prime rate ranged from a low of 2% in the 1940s to a high of 21.5% in the 1980s. As a result, the FOMC decreased the target range for the Fed Funds Rate to 0% –0.25% on March 15, 2020.

This step was taken as part of the Federal Reserve's attempts to mitigate the economic consequences of the COVID-19 epidemic.

Since the 1990s, the prime rate has been set at 300 basis points higher than the fed funds rate, resulting in a prime rate of 3.25% based on the Fed's most recent action. The current prime rate is 4% [as of May 2022].

Federal Reserve meeting

The prime rate significantly impacts the interest rates that banks charge their borrowers. Corporations and other financial organizations have traditionally received rates equal to or very similar to the prime rate.

Retail consumers with good credit and solid credit histories who obtain mortgages, small business loans, and vehicle loans receive interest rates that are somewhat higher than but based on the prime rate.

Lenders provide rates much higher than the prime rate to applicants with low credit scores or other risk characteristics, hence the name "subprime loan."

The exact amount of interest charged on a such loan is not fixed. Different lenders may not assess the risk of a borrower in the same way.

Piggy bag

This indicates that its applicant can save money by shopping around. Nonetheless, all subprime lending rates are more significant than the prime rate.

Borrowers may unintentionally enter the subprime loan market by responding to a mortgage advertisement when they qualify for a better rate than when they follow up on the ad.

Borrowers should constantly examine whether they are eligible for a better rate than they have.

Higher interest rates on it might mean tens of thousands of dollars more in interest payments over the life of the loan.

Types

Types

They are divided into four categories: interest-only loans, fixed-rate loans, adjustable-rate loans, and subprime dignity loans. They create a global subprime loan market in which borrowers borrow money from banks and mortgage originators and then repack and sell the loans to investors.

1. Subprime Interest-Only Loan

Borrowers pay the interesting part of the loan solely during the early stages. As a result, the initial monthly payments are less expensive. However, the difference might be fairly significant when payments are raised in subsequent periods.

2. Subprime Fixed-Rate Loan

The interest rate on such loans remains constant during the loan term. On the other hand, the loan duration is often longer than the standard loan.

While the average loan term is roughly 30 years, a fixed-rate subprime loan can last 50 years. As a result, the total interest paid on a fixed-rate loan tends to be more significant.

3. Subprime Adjustable-Rate Loan

The interest rate on such loans is fixed for the first period of the loan and then shifts to a variable rate. As a result, the interest rate for the loan's latter term will fluctuate with the market.

4. Subprime Dignity Loan

Borrowers must make a down payment of 10% of the loan amount and accept a higher interest rate for the loan's initial term - a usual time range is five years.

If the borrowers complete their payments on time and demonstrate their creditworthiness, the interest rate will gradually fall to the prime rate.

The mortgage originators were packing to sell off low-value mortgages to investors worldwide.

As a result, the mortgage market lent out 600 billion USD in 2006. Moreover, the U.S.'s real home price had arrived at its peak, increasing 85% compared to 1997.

Characteristics of Borrowers

A subprime borrower is someone a lender considers a relatively high credit risk. As a result, subprime borrowers have lower credit scores and are more likely to have a history of delinquencies and account denials on their credit reports.

Subprime borrowers may also have a bad credit history, which means their credit reports show little or no activity on which lenders can make judgments.

Credit bureaus give credit reports and credit ratings to lenders, which they use to make loan decisions. Credit scores are determined in several ways; the higher the score, the better the person's credit is thought to be.

The FICO score is the most extensively utilized credit score.

Characteristics

Certain qualities are shared among loan applicants. These are the following:

  • Low earnings: unemployment or do not have a full-time work
  • A credit score of less than 600
  • A debt-to-income ratio of 0.5 or more.
  • A bad credit history: Defaulting on bills for 90 days or more, having outstanding debts sent to collectors, going through a mortgage foreclosure or repossession, or applying for bankruptcy relief
  • Late payments on credit cards or loans
  • Have gone insolvent at least once in the last 60 months
  • Have had a foreclosure in the previous 24 months
  • A new company, retiree, or self-employed

If a borrower possesses any of the traits mentioned above, it does not rule out the possibility of obtaining a loan; nonetheless, the process becomes more complex.

To maximize the likelihood of loan acceptance and lower the interest rate, the borrower should fix any debt or credit difficulties before applying for a loan.

In 2008, the subprime crisis was caused by human psychology, which was spreading by "the 'irrational exuberance at the prospects for profits."

There are reasons for endogenous, because of the overly aggressive mortgage sales and complacent borrowers to feed the housing boom.

Thus, people were greedy and wanted to make money and buy a home with a financial mortgage product without justifying their financial circumstances. As a result, it finally fed the bubble of home prices.

Benefits

Subprime mortgages, also known as non-prime mortgages, are designed for customers with credit ratings below 600 and those who cannot obtain conventional loans.

Conventional loans are more readily available and usually come with better conditions, such as lower interest rates.

Subprime mortgages significantly contributed to the financial crisis that triggered the Great Recession. Many subprime mortgages were granted in the years preceding the financial crisis, and borrowers could not repay them.

According to a Credit Union National Association examination of Home Mortgage Disclosure Act data, nearly 30% of all mortgages issued in 2006 were subprime.

While subprime mortgages are still available today (often referred to as non-qualified mortgages), they are subject to stricter regulations. They also offer higher interest rates and need a more significant down payment than traditional loans.

Benefits

  1. Borrowers with low or weak credit ratings may be eligible for such loans, including mortgages and personal loans.
  2. It can consolidate debt and make payments more manageable.
  3. Borrowers' credit ratings may improve if they make regular payments on such loans.
  4. They enable borrowers to purchase homes and other items they would not have been able to afford otherwise.

In 2008, the U.S. government and Fed focused excessively on preventing recession and deflation by carrying loose monetary policy.

Thus, they provided a low rate of Fed and fixed-rate conventional mortgages to encourage the economy to be active and avoid falling home prices.

Indeed, they succeeded and built a vision for all investors that the U.S. financial market would never go down. It also led to the boom of home prices --- kept prices rising, and finally dropped suddenly in 2008 [Subprime mortgage crisis].

Limitations

Limitations

  1. These loans have higher interest rates to compensate for the increased credit risk.
  2. Larger interest rates than on conventional loans might result in higher monthly payments.
  3. Predatory lenders frequently charge uneducated consumers exorbitant interest rates and fees.

Example:

For example, the APR for a vehicle loan might include expenses such as the origination charge. The annual percentage rate (APR) estimates how much it will cost you to borrow money for an automobile.

For example, a borrower with a FICO® score of 720 to 850 would be eligible for a fixed APR of 4.55% on a $20,000 new automobile loan over 60 months [$2399].

On the other hand, someone with a FICO score of 590 to 619 may be eligible for a loan with an APR of around 16% [$9182].

There is a significant difference in the total amount of interest paid over the life of the loan, with the subprime borrower, in this case paying $6,783 more in interest.

You risk defaulting on your loan when you don't pay your bills on time.

And if you default on an auto loan, your automobile may be repossessed, giving subprime auto lenders a means to recuperate some of their money by reselling your confiscated vehicle.

Thus, while subprime lending increases the number of individuals who can buy houses, it also makes it more difficult for those people to do so and raises the likelihood of loan default. Defaulting harms both the borrower's credit score and the lender's.

Defenders of the new subprime mortgages argue that borrowers are not permanently obligated to pay those high percentage interest rates.

Once the purchasers can demonstrate that they can pay their mortgages on time, their credit ratings should rise, and they should be able to refinance their house loans at cheaper interest rates. This resulted in the creation of an irreality report.

Special Considerations

On lengthy-term loans, such as mortgages, the additional percentage points of interest frequently equate to tens of thousands of dollars in extra interest payments over the life of the loan.

Right consideration

This can make repaying subprime loans difficult for low-income borrowers, as it did in the late 2000s. In 2007, many borrowers with subprime mortgages began to fail.

Finally, the subprime catastrophe contributed significantly to the financial crisis and the subsequent Great Recession. As a result, several large banks exited the subprime lending market.

While financial institutions might provide subprime rates, some lenders specialize in high-interest subprime loans.

These lenders, it may be argued, provide borrowers who cannot obtain low-interest loans with the ability to access funds to invest, build their enterprises, or purchase houses.

Subprime lending is sometimes seen as predatory lending, the practice of making loans at exorbitant interest rates to borrowers to trap them into debt or increase their probability of failing.

However, acquiring a subprime loan may be a viable alternative if the loan is intended to pay off higher-interest-rate obligations, such as credit cards, or if the borrower has no other means of obtaining credit.

Related

[Why to choose WSO: We are the best company to help you to prepare for investment banking, private equity and hedge funds, etc., interviews.]

RE_Modeling_Course

Everything You Need To Build Your RE Modeling Skills

To Help You Thrive in the Most Rigorous RE Interviews and Jobs.

Learn More

Researched and authored by JunFeng Zhan | LinkedIn

Edited by Aditya Murarka | LinkedIn

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources: