Subprime mortgage lending is a relatively new but fast-growing component of the mortgage industry. Lately, however, subprime lenders have come under fire for their tactics -- specifically, for how their tactics relate to the increasing number of home foreclosures in the United States.
But what exactly is a subprime mortgage loan? How are they related to the current rise in foreclosures? And how can you protect yourself if you find yourself in need of a subprime mortgage loan?These are some of the questions we will answer in this article, a guide to subprime lending and loans.
What is a Subprime Mortgage Loan?
In this context, a subprime loan is a mortgage loan made to a borrower who would not normally qualify for a loan, perhaps due to bad credit issues or other financial problems. Subprime lenders will charge these borrowers a higher interest rate for potential losses the lender might incur (should the borrower default on the mortgage loan).
A History of Subprime Lenders
The number of subprime mortgages rose dramatically through the mid 1990's through early 2000's, as increased competition (largely from online mortgage lenders) forced lenders to offer a broader range of mortgage products.
Subprime lenders, as they became known, tried to outmaneuver competitors by offering mortgage loans to borrowers that their competitors were turning away. In other words, they offered subprime mortgage loans to subprime borrowers, usually with a much higher interest rate.
At an annual housing policy meeting in 2004, Governor Edward Gramlich (then a member of the Board of Governors of the Federal Reserve system) had the following remarks about subprime mortgage lending.
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| Subprime Mortgage Loans - A Borrower's Guide to Subprime Lending |
On the advantages of subprime lending: "The obvious advantage of the expansion of subprime mortgage credit is the rise in credit opportunities and homeownership. Because of innovations in the prime and subprime mortgage market, nearly 9 million new homeowners are now able to live in their own homes, improve their neighborhoods, and use their homes to build wealth."
On the challenges of subprime lending: "While the basic developments in the subprime mortgage market seem positive, the relatively high delinquency rates in the subprime market do raise issues. ... For mortgage lenders the real challenge is to figure out how far to go. ... If lenders do make new loans, can conditions be designed to prevent new delinquencies and foreclosures?"
So there are two sides to the issue of subprime lending. Yes, they extend home ownership to many Americans who might not otherwise afford it. But they are also a contributing factor in the number of home foreclosures in the United States.
Current Criticism of Subprime Mortgages
As the number of foreclosures continued to rise through 2000 to 2006, data analysis suggested a strong link between rising foreclosures and the subprime lending market. Predictably, the federal government got involved and began to scrutinize subprime mortgage lenders.
As a result of increased pressure, banking regulators have tightened their standards for mortgage lending. According to Randall Kroszner, current Federal Reserve Board Governor: "This guidance ... underscores that the Federal Reserve and other banking regulators expect lenders to make sure subprime borrowers not only can afford their monthly payments while the introductory rate is in effect but also after the interest rate resets."
When he refers to "interest rate resets," he is talking about adjustable rate mortgages. With an adjustable rate mortgage, the interest rate adjusts (or resets) after an introductory period of lower interest. The adjustable rate mortgage, or ARM, is another piece of the puzzle connecting subprime lending and foreclosures.
The Subprime-ARM-Foreclosure Connection
As mentioned above, adjustable rate mortgages (or ARM loans) have a role in the subprime foreclosure fiasco of late. The best way to illustrate how ARM loans relate to subprime mortgage foreclosures is to look at an example scenario. The borrowers in this scenario are fictitious, but the scenario itself is realistic and happens every day in this country.
Bob and Jane Smith are shopping for a home mortgage loan, but they are having trouble finding a willing lender because of some credit problems in their past. Eventually, they find a mortgage lender who is willing to loan them money under subprime conditions. Essentially, they extend a loan to the Smiths, but they charge a high interest rate in response to the couple's bad credit history.
At first, the Smiths are concerned with the high interest rate. But the mortgage will be an adjustable rate mortgage with a lower interest rate in the first three years. So the Smiths reason that they can refinance the mortgage before the ARM loan adjusts (or "resets"), thus avoiding the payment shock that can come from higher interest rates.
Two and a half years fly by, and before they know it, the Smiths are facing the uncertainty of their ARM loan adjusting to new interest rates. A higher interest rate (which is likely) could significantly increase the size of their monthly mortgage payment. So the Smiths try to refinance the mortgage. The trouble is that the couple has not improved their credit situation since they took out the subprime mortgage loan, so they are unable to find a favorable refinance loan -- one that won't make their situation worse by lumping closing costs on top of everything else.
So the adjustable rate mortgage resets to a higher interest rate, the Smiths have trouble making the new mortgage payments, and they end up becoming another foreclosure statistic.
On the challenges of subprime lending: "While the basic developments in the subprime mortgage market seem positive, the relatively high delinquency rates in the subprime market do raise issues. ... For mortgage lenders the real challenge is to figure out how far to go. ... If lenders do make new loans, can conditions be designed to prevent new delinquencies and foreclosures?"
So there are two sides to the issue of subprime lending. Yes, they extend home ownership to many Americans who might not otherwise afford it. But they are also a contributing factor in the number of home foreclosures in the United States.
Current Criticism of Subprime Mortgages
As the number of foreclosures continued to rise through 2000 to 2006, data analysis suggested a strong link between rising foreclosures and the subprime lending market. Predictably, the federal government got involved and began to scrutinize subprime mortgage lenders.
As a result of increased pressure, banking regulators have tightened their standards for mortgage lending. According to Randall Kroszner, current Federal Reserve Board Governor: "This guidance ... underscores that the Federal Reserve and other banking regulators expect lenders to make sure subprime borrowers not only can afford their monthly payments while the introductory rate is in effect but also after the interest rate resets."
When he refers to "interest rate resets," he is talking about adjustable rate mortgages. With an adjustable rate mortgage, the interest rate adjusts (or resets) after an introductory period of lower interest. The adjustable rate mortgage, or ARM, is another piece of the puzzle connecting subprime lending and foreclosures.
The Subprime-ARM-Foreclosure Connection
As mentioned above, adjustable rate mortgages (or ARM loans) have a role in the subprime foreclosure fiasco of late. The best way to illustrate how ARM loans relate to subprime mortgage foreclosures is to look at an example scenario. The borrowers in this scenario are fictitious, but the scenario itself is realistic and happens every day in this country.
Bob and Jane Smith are shopping for a home mortgage loan, but they are having trouble finding a willing lender because of some credit problems in their past. Eventually, they find a mortgage lender who is willing to loan them money under subprime conditions. Essentially, they extend a loan to the Smiths, but they charge a high interest rate in response to the couple's bad credit history.
At first, the Smiths are concerned with the high interest rate. But the mortgage will be an adjustable rate mortgage with a lower interest rate in the first three years. So the Smiths reason that they can refinance the mortgage before the ARM loan adjusts (or "resets"), thus avoiding the payment shock that can come from higher interest rates.
Two and a half years fly by, and before they know it, the Smiths are facing the uncertainty of their ARM loan adjusting to new interest rates. A higher interest rate (which is likely) could significantly increase the size of their monthly mortgage payment. So the Smiths try to refinance the mortgage. The trouble is that the couple has not improved their credit situation since they took out the subprime mortgage loan, so they are unable to find a favorable refinance loan -- one that won't make their situation worse by lumping closing costs on top of everything else.
So the adjustable rate mortgage resets to a higher interest rate, the Smiths have trouble making the new mortgage payments, and they end up becoming another foreclosure statistic.
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| Subprime Mortgage Loans - A Borrower's Guide to Subprime Lending |
This kind of scenario happens every day in the United States. Just watch your local news for a week straight, and you're almost guaranteed to see a story about mortgage refinancing, home foreclosures, subprime lending, or all three topics combined.
Be Smart About Subprime Mortgages
One cannot simply say that subprime mortgages are good or bad. They can be both things, depending on the situation. But one thing is for certain. There is a direct link between subprime lending, adjustable rate mortgages, and the number of home foreclosures in this country. So the best you can do to protect yourself (if you find yourself in a subprime borrowing situation) is to understand how these things are related, seek input from an unbiased financial advisor, and plan accordingly.
Be Smart About Subprime Mortgages
One cannot simply say that subprime mortgages are good or bad. They can be both things, depending on the situation. But one thing is for certain. There is a direct link between subprime lending, adjustable rate mortgages, and the number of home foreclosures in this country. So the best you can do to protect yourself (if you find yourself in a subprime borrowing situation) is to understand how these things are related, seek input from an unbiased financial advisor, and plan accordingly.
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