How Subprime Mortgages Work


couple holding model house
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Many people need subprime mortgages to break into the housing market.

Owning a home has long been touted as the "American dream" -- a palpable opportunity that the economy would ideally be able to provide to every working family. However, various factors in the complex financial system caused the housing market in the United States to go through a dramatic boom and bust during the first decade of the 2000s. One of the factors that caused both the rise and dramatic fall of the market was the use of tricky lending programs, called subprime mortgages, which enable people with shaky credit ratings to secure home loans.

The practice of lending money to people with a weak or limited credit history is called subprime lending. One misconception about the term "subprime" is that it refers to the interest rates attached to the loans. "Subprime" generally refers to the credit rating of the borrower. Subprime borrowers generally have a credit score below 620 on a scale of roughly 300 to 850 (or 900, depending on the particular scoring system used). Most consumers land in the mid to high 600s and 700s [source: Bankrate.com]. However, during the housing boom, many who could have qualified for a traditional home loan instead took out a subprime loan, partly due to aggressive mortgage broker tactics, such as approving loans more easily or not fully explaining stricter repayment terms [source: Brooks].

The interest rates on subprime mortgages can vary wildly. They're partially based on a variety of risk-based factors including:

  • Credit score
  • Size of down payment
  • Number of delinquencies (late payments listed on your credit report)
  • Types of delinquencies

For more on mortgage rates, read How are mortgage rates determined?

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The sharp rise in subprime mortgage lending began in the mid-1990s and accounted for roughly 20 percent of home loans in 2006 [source: Federal Reserve]. On the plus side, subprime mortgages allow people with poor credit a chance to get into a market previously unavailable to them with standard home loans. The downside of this scenario is that these loans are more likely to go into default, meaning that the borrower fails to make payments on the loan. The large number of foreclosures from subprime mortgages has had a drastic impact on the U.S. housing bust and overall economy. Lenders were also hit hard, with some going under completely.

Another negative aspect of the subprime market is the rise in accusations that lenders target minorities -- a practice known as predatory lending. These lenders prey upon the inexperience of the borrower in many ways. They may overvalue your property, overstate your income or even lie about your credit score in order to set sky-high interest rates. They also encourage frequent refinancing to get a "better" rate, and then roll the high closing costs in to the loan.

In this article, we'll look at some examples of subprime mortgages to help you determine whether one might be right for you. We'll also examine the subprime crisis and what's being done about it.

Subprime Specifics

Subprime Credit Cards

Another way subprime lending rears its ugly head is in the credit card industry. Subprime credit cardholders can expect to pay a variety of additional fees not typically found with prime cards. Yearly fees, up-front fees, and higher late and over-the-limit fees are common.

The late payment grace period is also usually not available to a subprime cardholder. One fee typically leads to another, resulting in a late fee that's figured into the balance, leading to over-the-limit fees.

The system itself seems geared toward making money off the people that had financial difficulties to begin with. If you have a subprime card, it's very important to stay on top of your payments for an extended period. This way, you may actually be able to improve your credit.

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. (Read How Interest-only Loans Work for more information.)

According to the mortgage calculator at Bankrate.com, the increase in the monthly payments on a 2/28 interest-only subprime ARM can be dramatic:

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Loan Rate Monthly payment
First two years $200,000 7% $1,330.60
Third year $200,000 11% $1,922.96

As you can see, it's likely when the introductory period runs out that you'll be in store for a much higher monthly payment. While it's possible to refinance after this 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.

They may also have a balloon payment attached. This is when the remainder of the loan is due after the introductory period in one lump sum. Borrowers generally plan on refinancing at this point, but this isn't always possible. Even if it is, you can end up with much higher rates.

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].

It's also important to remember that your credit is affected by anything you have co-signed with another person. People who get divorced are often surprised to find out that their former spouse has defaulted on loans that ruin their credit score.

In the next section, we'll examine the subprime mortgage crisis and what's being done to fix it.

Subprime Mortgage Crisis

Neighbor Works

Not all the news is bad in the world of subprime lending. One nonprofit organization called Neighbor Works America is doing something about it. Through its Center for Foreclosure Solutions, the organization has joined forces with mortgage and insurance companies to reach out to borrowers in need. It trains foreclosure counselors to assist borrowers and inform communities of their options.

Neighbor Works 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.

Neighbor Works received more than 100,000 calls in 2007 on their hotline. To explore your options, you can call the hotline at 888-995-HOPE, or visit their Web site.

The drastic increase in the number of defaults and foreclosures on subprime mortgages beginning in 2006 led to a subprime mortgage crisis. By 2008, the overall losses from subprime mortgages reached about $250 billion [source: Rose]. And, due to the complex repackaging of subprime mortgages into investments, this crisis in the housing market contributed to a financial meltdown in 2008 that contributed to a national economic disaster.

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. It's also common for someone looking to get into the housing market to overstate his or her income to secure a loan.

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 are more likely to have a subprime loan than Caucasians. 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 [source: CRL]. Since 2007, the NAACP has filed more than a dozen lawsuits against leading subprime lenders for practicing "systematic, institutionalized racism in making home mortgage loans" [source: CNSNews.com].

To understand how the subprime mortgage crisis led to the worst U.S. recession since the Great Depression, read How can mortgage-backed securities bring down the U.S. economy? For more information on mortgages and the financial system, please explore the links on the following page.

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Sources­

  • Kroszner, Randall S. "At the Consumer Bankers Association 2007 Fair Lending Conference." federalreserve.gov, November, 5, 2007. http://www.federalreserve.gov/pubs/bulletin/2007/pdf/hmda06draft.pdf
  • Lewis, Holden. "Fixing subprime mortgage lending isn't easy." bankrate.com, April 18, 2007. http://www.bankrate.com/brm/news/mortgages/
    20070308_Fed_guidance_loan_rules_a1.asp
  • "The NAACP Filed an Historic Lawsuit Against Mortgage Lenders Alleging Racial Discrimination." naacp.org. July 17, 2007. http://www.naacp.org/get-involved/activism/alerts/
    110aa-2007-7-11/index.htm
  • Shaw, Annie. "Are you subprime?" MSN Money, October 7, 2007. http://money.uk.msn.com/guides/dealing-with-debt/
    article.aspx?cp-documentid=6292746
  • Schlomer, Li, Ernst, and Keest. "Losing Ground: Foreclosures in the Subprime Market and Their Cost to Homeowners." Center for Responsible Lending, 2006. http://www.responsiblelending.org/pdfs/
    Fclosure-exec-summary-standalone.pdf
  • "Subprime Mortgages." bankrate.com, May 1, 2006. http://www.bankrate.com/brm/green/mtg/basics2-4a.asp?caret=8
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