Subprime Mortgage

What is a Subprime Mortgage?

A subprime mortgage refers to a loan provided to borrowers with low credit ratings. These loans typically come with a higher interest rate due to the increased default risk associated with them.

These borrowers, the primary recipients of subprime mortgages, do not have access to prime or ordinary mortgages as they pose a higher-than-average risk of defaulting.

Subprime mortgages are granted to such borrowers, which helps them own a house despite having a poor credit rating.

To offset the elevated risk, lending institutions impose significantly higher interest rates on subprime mortgages than prime ones. Often, these mortgages feature adjustable interest rates, which can potentially increase at specified points in time.

Since the 2008 Global Financial Crisis, caused by a widespread default on these high-risk mortgages, financial institutions have implemented stricter criteria and regulatory measures to prevent a similar situation from occurring again.

Therefore, subprime borrowers should carefully understand the terms and conditions of these mortgages, explore alternative options such as government-backed loans or assistance programs if available, and then make an informed decision according to their financial situation.

In this way, borrowers can achieve their dream of homeownership while minimizing any financial risks or challenges that may arise along the way. 

Understanding Subprime Mortgages

The term "subprime" refers to the below-average credit score of the borrower, signaling the possibility of him being a credit risk. Thus, lenders charge higher interest rates to compensate for the risk of lending them loans.

Unlike ordinary mortgages, the defining characteristic of subprime mortgages is the credit score. A credit score of less than 620 implies that the borrowers have no access to an ordinary mortgage and must opt for subprime mortgages if they hope to buy a house.

Generally, a good credit score is between 670 and 740. The borrowers must have a good credit score for the lenders to offer them favorable mortgage terms at low-interest rates.

A good credit rating can result from paying credit card balances in full each month and timely payments for bills and loans. Interest rates for subprimes depend on different variables, including credit rating for loan seekers, the level of down payment, and outstanding debts.

Thus, those with low credit profiles should allow themselves to increase their credit scores and then apply for loans. In this way, they might obtain a prime loan with lower rates than subprimes.

Types of Subprime Mortgages

There are various subprime mortgages, each designed to cater to borrowers with different financial conditions and preferences. Borrowers can opt for a certain mortgage plan according to their feasibility.

Each mortgage type offers distinct advantages and risks. Borrowers should carefully assess their financial circumstances and goals before selecting the most suitable option.

In this regard, choosing between these mortgages has an immense impact on the long-term cost and viability of owning a house. Therefore, it is advisable for individuals seeking loans to understand these subtypes better.

Interest-Only Mortgage 

This type of sub-prime mortgage requires borrowers to begin by paying just interest on a loan over the first few years. This option is preferable for borrowers who intend to refinance or sell their homes before commencing on the principal repayment plan.

For example, let's suppose John acquires a mortgage loan worth $250,000, which is interest only, and let’s say the annual interest rate ranges from 5%. Here’s what his monthly payments will look like:

Monthly Interest Payment = $250,000 * (0.05 / 12) = $1,041.67

During the initial years, John will pay only the monthly interest amount of $1,041.67. Subsequently, he will have to pay both the basic principal amount and the interest. Here, John may refinance the mortgage or sell the house if it increases in value before the principal payment phase begins.

Option Adjusted Mortgage

This mortgage grants borrowers the flexibility to determine their monthly payments according to their financial situations. This could be desirable for many borrowers with low credit scores but has limitations.

If a borrower repays less than the monthly interest charges, the remaining debt is added back onto the principal, thereby increasing the ultimate financial burden as time passes.

For example, imagine Lisa chooses an option-adjusted mortgage of $200,000 at an interest rate of 6%. Here’s what her monthly payments should look like:

Monthly Interest Payments = $200,000 * (0.06 / 12) = $1,000

As her monthly payments are flexible, she chooses a low monthly payment of $900. Therefore, the unpaid portion gets added to her principal amount each month:

Monthly Payments Done = $900

Additional Amount Added to Principal = $1,000 - $900 = $100

Since her monthly payment is lower than the interest rate, her principal balance increases by $100 each month. Over time, this can result in a growing pile of principal amounts, ultimately leading to higher overall costs in the long run.

Balloon Payment Mortgage

Similar to the option-adjusted mortgage, this subprime variant involves lower initial payments. However, a significant "balloon" payment becomes due after a set period to cover the remaining mortgage balance.

Borrowers often face challenges in meeting this lump-sum payment, which may lead to higher chances of default.

For example, suppose Mike buys a balloon payment mortgage of $180,000 at an interest rate of 4%. Here’s how his payments work:

Monthly Interest Payment = $180,000 * (0.04 / 12) = $600

During the initial years, Mike will pay only the monthly interest, worth $600. However, he must settle with a large “balloon” payment after this time to cover any remaining outstanding principal.

Long-Term Fixed-Rate Mortgage 

A long-term fixed-rate mortgage extends for 40 to 50 years. This type aims to provide more extended payment periods, potentially making homeownership more accessible for subprime borrowers.

For example, let us assume that Sarah takes out a 45-year fixed-rate mortgage of $220,000 at an interest rate of 5%. Therefore, her monthly payments will look like:

Monthly Interest Payments = $220,000 * (0.05 / 12) = $916.67

Her fixed monthly payment, covering both principal and interest, is approximately $916.67, allowing her to budget more comfortably over the extended 45-year term.

Advantages of Subprime Mortgages

Despite their controversial reputation, subprime mortgages come with certain advantages for both borrowers and lenders.

They serve as a financial tool that can offer access to homeownership and credit improvement opportunities for certain borrowers. Simultaneously, they can provide financial institutions with higher returns and portfolio diversification.

Let us look into some of the major advantages which are associated with these mortgages:

1. Accessibility: They make it possible for individuals with lower credit scores or no credit history to fulfill their dream of homeownership, which is often not achievable with prime mortgages.
2. Credit Improvement: Subprime mortgages, particularly those with initial interest-only payments, offer borrowers the opportunity to allocate their resources strategically.
   • They can focus on paying off other high-interest debts or improving their credit scores during the interest-only period.
3. Higher Returns for Lenders: From the perspective of financial institutions, such mortgages can be attractive because they often yield higher returns than prime mortgages.
   • The higher interest rates associated with subprime loans increase lenders' profitability.
4. Economic Stimulus: Monthly installments paid by subprime borrowers inject funds into the market. Therefore, financial institutions can give individuals more loans or invest in some organizations with these funds.

Disadvantages of Subprime Mortgages

Assessing the risks attached to subprime lending is essential for any financial institution.

Let us look at some of the major disadvantages that one should consider for these mortgages:

1. High Risk-Reward Ratio: There's a higher likelihood of default when it comes to these loans, making them riskier for lenders.
   • This may affect the lender's profitability if the potential rewards are insufficient to offset the risks.
2. Property Price Dependency: Subprime mortgages often require borrowers to pay only the interest amount for the initial years. So, before the principal payment kicks in, borrowers often plan to refinance or sell their home at a profit.
   • However, when housing prices start falling, refinancing or selling homes at a loss becomes difficult for them, eventually resulting in defaults.
     • This was one of the factors that played a major role in the 2008 Global Financial Crisis.
3. High Costs: Subprime borrowers face elevated borrowing costs due to the added risk assumed by lenders. These higher interest rates and fees can contribute to the overall financial burden of borrowers.
4. Affordability Challenges: While subprime mortgages are marketed as an affordable option for low-credit-score individuals, they often lead to affordability challenges.
   • As monthly payments increase when principal payments commence, borrowers may struggle to meet their financial obligations, frequently resulting in defaults.

Balancing the advantages and disadvantages is crucial for borrowers, lenders, and policymakers to make informed decisions and mitigate the risks associated with these loans.

The Subprime Mortgage Crisis of 2008

The 2008 Global Financial Crisis was caused by a widespread default on subprime mortgages, particularly NINJA loans (No Income, No Job, and No Assets). These loans required no down payment and often lacked income verification.

Many borrowers faced the possibility of foreclosure as they struggled to keep up with their mortgage payments, leading to the nightmare of leaving their homes. The teaser rates initially offered on subprime mortgages escalated over time, making it challenging to pay the principal.

The crisis also highlighted the dark side of mortgage-backed securities (MBS), a significant contributor to the market collapse. Initially profitable, these securities lost value as borrowers struggled to sell or refinance properties amidst falling home prices and rising interest rates.

Financial institutions like AIG, Citi Group, and Bank Of America, which had invested heavily in mortgage-backed securities, suffered severe financial repercussions. Such institutions, described as ‘too big to fail,’ posed a danger to the world economy.

Many other banks and financial institutions faced the burden of defaulted mortgage payments, resulting in nearly 9 million jobs lost between 2008 and 2009. This large-scale financial crisis indicated risky lending practices, poor supervision, and the interconnection of global financial markets.

Below is an interesting video explaining the 2008 Global Financial Crisis in detail. Do check it out to gain a further understanding of this topic.

Conclusion

Subprime mortgages are loans granted to people with low credit ratings. Since these loans are risky, lenders demand high interest rates from the borrowers.

Borrowers under this category should improve their credit ratings before applying for loans so that they may get their hands on prime mortgages with better interest rates than the subprimes.

Despite being debarred from prime mortgages, subprime loans create avenues for individuals to access home ownership. However, higher interest rates on these loans can significantly surge the cost of owning a house.

Both borrowers and lenders must understand the advantages as well as risks attached to these mortgages while assessing other alternatives as they traverse through this financially stormy terrain.

Researched and authored by Sauryan Pandey | LinkedIn

Reviewed and edited by Parul Gupta | LinkedIn

Free Resources

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

• Interest-Only Mortgage
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