Definition
A subprime mortgage refers to a type of home loan that’s given to borrowers with poor credit histories, typically with a credit score below 600-650. Because of the higher risk associated with lending to these borrowers, lenders often charge higher interest rates for subprime mortgages. These loans can lead to costly monthly payments and might contribute to financial distress if the borrower struggles to keep up with payments.
Key Takeaways
- Subprime Mortgages are types of loans granted to borrowers with poor credit histories which typically have higher interest rates to compensate for the higher credit risk.
- These mortgages are structured to help individuals with less than perfect credit scores purchase a home, but they pose more risk to lenders due to the possibility of loan default.
- The subprime mortgage crisis, which occurred from 2007 to 2010, has demonstrated the significant economic impact poorly regulated subprime lending can have, leading to a system wide credit crunch and a severe global recession.
Importance
The term “Subprime Mortgage” refers to a type of mortgage that is usually granted to home buyers with poor credit history.
It is important because it poses a larger degree of risk for the lender due to the borrower’s financial profile, typically resulting in higher interest rates compared to standard mortgages.
The volatility of subprime mortgages became highly notable during the 2008 financial crisis when a significant number defaulted, contributing to a severe housing market downturn and the subsequent global economic recession.
Thus, understanding subprime mortgages aids in comprehension of financial risk management, economic patterns, and the potential wider implications for the economy.
Explanation
A subprime mortgage is a type of loan that’s offered to individuals with poor credit scores, who might not be eligible for conventional mortgages due to the high risk they pose to the lender. It’s a financial instrument purposefully designed to provide an opportunity for these individuals to purchase a home.
By extending credit to these high-risk borrowers, lenders offer them an opportunity to improve their credit standing by maintaining a regular mortgage payment schedule. This practice is meant to be inclusive, expanding the possibility of homeownership to a wider demographic.
Subprime mortgages are used by various financial institutions to stimulate economic activity and help individuals and families, who would otherwise be excluded, become homeowners. The interest rates on these mortgages are often significantly higher compared with prime mortgages, reflecting the higher risk associated with lending to individuals with compromised credit histories.
These loans, while financially risky for both lender and borrower, can facilitate an increase in property ownership rates and contribute to overall economic growth if managed well. However, it’s essential to note that subprime mortgages can also contribute to economic downturns and crises, as was seen in the 2008 financial crash, if the associated risks aren’t adequately managed.
Examples of Subprime Mortgage
The 2008 Financial Crisis: The most well-known example of subprime mortgages at work is during the financial crisis of
Leading up to this time, many financial institutions had been issuing subprime mortgages, or mortgages that were given to individuals with low creditworthiness. When an inevitable wave of defaults occurred, the banks were left holding numerous bad loans. This fueled a housing market crash and subsequently, a global financial crisis.
The Housing Bubble in the United States (2000-2007): This is an example of a widespread use of subprime mortgages. Many mortgage lenders started offering loans to those with low credit scores or with little to no down payment. The idea was to eventually refinance these loans as home prices went up. Unfortunately, when the housing market crashed, many of these borrowers couldn’t make payments or refinance, and fell into foreclosure.
Countrywide Financial Corporation: This company was one of the largest mortgage lenders in the United States during the housing boom. It became famous for its aggressive lending strategies, including the widespread use of subprime mortgages. When the real estate bubble burst in 2007, Countrywide was hit hard due to the large number of subprime mortgages in its portfolio and was eventually bought by Bank of America in 2008 to save it from bankruptcy.
FAQs: Subprime Mortgage
1. What is a subprime mortgage?
A subprime mortgage is a type of mortgage that is normally issued by a lending institution to borrowers with low credit ratings. As such borrowers pose a higher risk for lenders, the interest rate charged on subprime mortgages is generally higher than that on prime mortgages.
2. Who qualifies for a subprime mortgage?
Borrowers who do not meet the stringent requirements of conventional mortgages often qualify for subprime mortgages. This includes individuals with a poor credit history, which may be due to late payments, bankruptcy, or other factors.
3. Is a subprime mortgage a bad thing?
While the higher interest rates mean that a subprime mortgage may cost more than a conventional mortgage, they can provide an opportunity for individuals with a poor credit score to secure a mortgage. Over time, if the borrower makes regular payments and improves their credit score, they may be able to refinance the mortgage to a lower interest rate.
4. What is the risk associated with subprime mortgages?
The principal risk of subprime mortgages is the higher likelihood of default. Due to the riskier nature of lending to individuals with a poorer credit score, subprime mortgages come with higher interest rates. If the borrower is unable to meet these higher repayments, this can lead to default. The default risk was one of the key factors that led to the financial crisis of 2007-2008.
5. Can I refinance a subprime mortgage?
Yes, provided that your credit score has improved since you first obtained the mortgage and you have maintained regular payments, it is often possible to refinance a subprime mortgage to get more favorable terms.
Related Entrepreneurship Terms
- Default
- Foreclosure
- Risky Lending
- High-Interest Rates
- Mortgage-Backed Securities
Sources for More Information
- Investopedia: An online source of free financial education as well as dictionary-like explanations of various finance terms including Subprime Mortgage.
- Consumer Financial Protection Bureau: A U.S. government agency that ensures banks, lenders, and other financial companies treat consumers fairly.
- Bankrate: A comprehensive resource providing expert advice and tools about personal finance, including information on Subprime Mortgage.
- Federal Reserve: The central bank of the United States that provides the nation with a safe, flexible, and stable financial and monetary system.
