How Subprime Mortgages Work

Subprime mortgages come in all shapes and sizes. The one factor that's generally consistent across the board is that the interest rate will be higher than the prime rate established by the Federal Reserve. The prime rate is what lenders charge people with good credit ratings.

One of the more common subprime loans has an adjustable-rate mortgage (ARM) attached. ARMs became increasingly popular during the housing boom because of their initial low monthly payments and low interest rates. Introductory rates for ARMS typically last two or three years. The rate is then adjusted every six to 12 months and payments can increase by as much as 50 percent or more [source: Bankrate.com]. If you hear about a 2/28 or a 3/27 ARM, the first number refers to the number of years at the introductory rate, the second to the number of years in the remaining period of the loan which are subject to the fluctuating rate.

Interest-only options are also often attached to subprime ARMs. These refer to when the first period of payments go only toward the interest rather than the principal of the loan. Let's look at a 2/28 interest-only ARM. This loan allows you to pay only on the interest during the two year introductory period at a lower set rate. After that, the full amount of the loan is recalculated over the remaining 28 years with a new rate.

According to Investopedia, the increase in the monthly payments on a 2/28 interest-only subprime ARM can be dramatic when compared to a fixed-rated 30-year mortgage. For example, if you buy a $350,000 home and put down $50,000, you have a $300,000 2/28 ARM mortgage with an initial interest rate of 5 percent. Your monthly payments will start out at about $1,900, assuming your property taxes are about $230 per month and homeowners insurance is about $66 per month.

If the interest rate stays 5 percent for two years, then rises to 5.3 percent, your mortgage payment would increase to $1,961. After two more years, the rate will be adjusted every six months, typically up. Compare that with a 30-year fixed-rate mortgage on the same loan with 5 percent interest, you would pay $1,906 per month indefinitely.

While it's always possible to refinance after the two-year period, the decline in appreciation values in the U.S. housing market during the housing bust made this difficult. It's also important to remember that every time you refinance, you must pay a new set of closing costs to your lender.

Subprime loans often have a prepayment penalty included in the terms. This means that if you choose to pay the loan off early, you must pay extra fees. And subprime loans might also have a balloon payment attached, which is when the last payment is intentionally larger than prior payments.

There are other factors aside from your credit score that determine whether you fit into the category of subprime. Lenders may deem a loan risky for borrowers who, although they have good credit scores, can't provide proof of income and assets, or borrow an unusually large percentage of their income, as well as a myriad of other reasons [source: Brooks].

Not all the news is bad in the world of subprime lending. One nonprofit organization called NeighborWorks America is doing something about it. Through its Mortgage Relief & Foreclosure department, the organization trains foreclosure counselors to assist borrowers and inform communities of their options.

NeighborWorks took action after learning that a common problem between subprime lenders and their clients is a lack of communication once the borrower falls into financial straits. Often, the borrower is ashamed or afraid to call his or her lender, even though there are actions that could be taken to prevent foreclosure. Lenders often have trouble locating the people in need of advice.

The drastic increase in the number of defaults and foreclosures on subprime mortgages beginning in 2006 led to a subprime mortgage crisis. By July 2008, one in five subprime mortgages were delinquent with 29 percent of ARMs were seriously delinquent. This eventually caused $7.4 trillion in stock market paper losses, and wiped out about $3.4 billion in real estate wealth.

The blame for the subprime mortgage crisis is shared among several factors. Many mortgage brokers steered their clients toward loans they couldn't afford. Previously, when someone wanted a loan, he or she would go directly to the bank. More and more, people were going to mortgage brokers to act as the go-between. The result was an industry that wasn't directly accountable when a loan goes bad. Mortgage brokers didn't suffer any penalty when a loan they drafted defaulted, so there wasn't much incentive to turn down applicants in this commission-based industry.

The unemployment rate was also a factor leading to the crisis. Midwestern states hit hard by auto industry layoffs ranked among the highest in foreclosures [source: Federal Reserve]. Many people had been counting on being able to refinance to make their loan affordable, but slowing appreciation rates in the housing market made it difficult or impossible. Once the introductory period on the subprime loans ran out, the new payments were more than many could handle.

The borrowers also must bear some responsibility. In a time when credit was easily attainable, many didn't read the fine print of their loan terms or simply took too big of a risk on a loan that they couldn't afford to pay back.

Another ugly facet of the subprime crisis is the assertion that many lenders exploited minorities in the rush to get rich. The Home Mortgage Disclosure Act (HMDA) of 1975 made it mandatory for lenders to maintain and disclose data in relation to their loans. In recent years HMDA numbers vary wildly across racial lines. Black and Hispanic borrowers were more likely to have a subprime loan. In fact, in 2006, there was a difference of 36 percent, with 53 percent of Blacks having subprime mortgages compared to only 17 percent for whites [source: Federal Reserve]. In addition, a 2006 study by the Center for Responsible Lending (CRL) found that when credit risk was equal, Blacks were still 31 percent to 34 percent more likely to receive a higher rate than whites.