The Risk of Subprime Mortgages by a New Name

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The Risk of Subprime Mortgages by a New Name

Investors, bankers, and homeowners all get shivers at the mention of the term “subprime.” There’s a very excellent explanation for this, too. One of the key causes of the Great Recession was subprime mortgages. However, they seem to be resurfacing under the moniker of “nonprime mortgages.”

On the market, there are several varieties of subprime mortgage arrangements. A rose by any other name, nevertheless, would smell as sweet? That may not always be the case. Continue reading to learn more about these mortgages and what they stand for.

Key Takeaways

  • A subprime mortgage is a special kind of loan given to those with bad credit who would not be eligible for standard mortgages.
  • In the form of nonprime mortgages, subprime mortgages are already resurfacing.
  • The three primary categories of subprime mortgages are fixed-rate, interest-only, and adjustable-rate mortgages.
  • Due to the possibility of a borrower default, these loans nevertheless carry a high level of risk.
  • New nonprime mortgages are subject to regulations and need thorough underwriting.

What Is a Subprime Mortgage?

A subprime mortgage is a form of loan given to those with bad credit who, due to their weak credit records, would not be eligible for traditional mortgages (scores of 640 or less, and often below 600).

Every subprime mortgage carries a significant degree of risk. Instead of the loan itself, the word “subprime” refers to the borrowers and their financial status. Compared to consumers with better credit ratings, subprime borrowers are more likely to default.

Subprime mortgages often have interest rates above the prime lending rate because subprime borrowers pose a greater risk to lenders. The down payment, credit score, late payments, and delinquencies on a borrower’s credit record are only a few of the variables that affect subprime mortgage interest rates.

Types of Subprime Mortgages

Interest-only mortgages, adjustable rate mortgages, and fixed-rate loans with periods of 40 to 50 years are the three primary subprime mortgage kinds (ARMs).

Fixed-Interest Mortgages

A fixed-rate mortgage, which is issued for a length of 40 or 50 years rather than the typical 30, is another sort of subprime mortgage. Although the borrower’s monthly payments are reduced due to the prolonged loan term, a higher interest rate is more likely to be associated with it. Lender to lender might provide a wide range of interest rates for fixed-interest mortgages. Use a resource like a mortgage calculator to find the best interest rates available.

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Adjustable-Rate Mortgages

A mortgage with an adjustable rate begins with a fixed interest rate and eventually, throughout the course of the loan, changes to a floating rate. A typical illustration is the 2/28 ARM. A 30-year mortgage with a two-year fixed interest rate before it is modified is known as a “2/28 ARM.” The 3/27 ARM, a common kind of ARM loan, has a fixed interest rate for three years before it becomes variable.

The variable rate for these loans is established using an index plus a margin. The SOFR is a popular index (secured overnight financing rate).During the early period of an ARM, the borrower’s monthly payments are typically lower. However, their mortgage payments often rise dramatically when their loans reset to the higher, variable rate. Of fact, the index and the state of the economy might also affect the interest rate over time, which would reduce the payment amount.

The situation was severely impacted by ARMs. Many homeowners realized their properties weren’t worth the purchase price as housing values began to fall. Due to this and the increase in interest rates, there were a great number of defaults. This resulted in a sharp rise in subprime mortgage foreclosures in August 2006 and the subsequent bust of the housing bubble the following year.

Interest-Only Mortgages

An interest-only mortgage is the third subprime mortgage type. The borrower only pays interest for the first five, seven, or ten years of the loan’s original term since principle payments are deferred. He is not compelled to make principle payments, but he may do so if he wants to.

When this period is over, the borrower either starts repaying the principle or decides to refinance the loan. If a borrower’s income fluctuates from year to year or if he wants to purchase a property and anticipates an increase in income within a few years, this may be a wise choice.

Dignity Mortgages

The dignity mortgage is a brand-new subprime loan type in which the borrower agrees to pay a higher rate of interest for a certain time, often five years, in exchange for a 10% down payment. The amount that has been paid toward interest goes toward lowering the mortgage debt after five years if he makes the required monthly payments on time, and the interest rate is dropped to the prime rate.

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Subprime Mortgages Today

After the housing bubble burst, getting a house loan with a credit score below 640 was next to impossible. Subprime mortgages are regaining popularity as the economy begins to recover. These types of house loans are becoming more and more popular with borrowers and lenders. Additionally jumping on the new subprime bandwagon was Wells Fargo. Prior to 2015, the bank would approve Federal Housing Administration (FHA) loans for prospective homebuyers with credit ratings as low as 600.

However, the Consumer Financial Protection Bureau (CFPB) imposes limitations on these subprime mortgages this time. A person authorized by the U.S. Department of Housing and Urban Development is required to provide homebuyer counseling to prospective homeowners. There are also limitations on interest rate hikes and other loan parameters for these new subprime mortgages. Additionally, all loans must be adequately underwritten.

The parameters of new subprime mortgages are restricted, including interest rate hikes.

They are also returning at a higher cost. Today, subprime mortgages may need down payments of up to 35% and come with interest rates as high as 8% to 10%.

Subprime Mortgages Are Risky

The organization or bank lending the money has the right to charge high interest rates because these mortgages are specifically for people who do not qualify for a prime rate mortgage—which typically means the borrower will have a difficult time repaying the loan. This gives the borrower an additional incentive to pay on time.

In contrast to individuals who have strong credit histories and can afford loans with lower interest rates, those who take out these loans may already be struggling with debt and face a more challenging and costly future.

Subprime Mortgage Meltdown

The Great Recession’s start is often attributed to subprime mortgages and the subprime crisis.

Between 2004 and 2006, a number of lenders were generous in approving these loans because to reduced interest rates, substantial capital liquidity, and the potential for significant profit. Lenders charged interest rates over prime on these higher risk loans in order to make up for the extra risk they took on.

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They also sold the mortgages to investors as repackaged assets after pooling them to pay for the mortgages. Due to the unexpected rise in the number of individuals who could afford mortgages, there was a severe housing scarcity, which drove up property prices and, in turn, the amount of financing that prospective homeowners required.

It seemed to be climbing steadily higher. The drawback was that loans were being extended to borrowers who were unable to repay them. The lenders lost every dollar they provided when a sizable percentage of borrowers started to fail on their mortgages and the number of foreclosed homes shot through the roof. Numerous financial institutions that made significant investments in the securitized packaged mortgages also did so. Many went through severe financial hardships, even filing for bankruptcy.

From 2007 to 2010, the subprime mortgage crisis persisted, spreading to financial markets and economies all over the globe before evolving into a worldwide recession.

The Bottom Line

Although subprime lending expands the pool of potential homebuyers, it also makes it more difficult for them to do so and raises the likelihood that they would fail on their loans. A default is detrimental to the lender as well as the borrower’s credit score.

The high percentage interest rates on the new subprime mortgages do not have to be paid by purchasers forever, according to their supporters. The purchasers’ credit ratings should rise if they can demonstrate that they can pay their mortgages on time, and they will then be able to refinance their house loans at cheaper interest rates.

In fact, many consumers who take out ARMs wager that by the time the variable rate kicks in, their credit will have improved enough for them to be eligible for new, more favorable financing.

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