Definition
A subprime mortgage is a type of home loan issued to prospective borrowers who have poor credit history, making them a high risk for lenders. These loans usually come with higher interest rates to compensate for the perceived risk. The term “subprime” refers to the sub-standard credit of the borrower.
Phonetic
The phonetic pronunciation of the phrase “Subprime Mortgage” is: /sʌbˈpraɪm ˈmɔːrɡɪdʒ/
Key Takeaways
Key Takeaways About Subprime Mortgages
- Definition and High Interest Rates: Subprime mortgages are a type of mortgage that is normally made out to borrowers with lower credit ratings. As a result of the borrowers’ decreased creditworthiness, represented by his or her credit scores, these mortgages usually carry higher interest rates to compensate for higher payment risks.
- Financial Crisis: Subprime mortgages played a significant role in the 2008 financial crisis. The housing boom led to an increase in subprime lending, and when housing prices fell, many subprime borrowers found themselves unable to refinance their mortgages or sell their homes at prices that would cover what they owed, leading to a spike in defaults.
- Risky for Both Parties: Subprime mortgages are often riskier for both lenders and borrowers. Lenders face the risk of borrowers defaulting and the subsequent loss on their investment. Borrowers, on the other hand, are at risk due to the higher interest rates and other generally less favorable terms of subprime mortgages.
Importance
Subprime Mortgage is an important term in business and finance because it refers to a type of loan granted to individuals with poor credit scores, usually less than 640. These individuals wouldn’t be able to qualify for conventional mortgages because lenders see them as high-risk borrowers due to their history of defaulting on loans or having late payments. Subprime mortgages carry a higher interest rate than prime mortgages to compensate for the risk the lender assumes. Despite being high-risk, subprime mortgages provide potential homeowners the ability to purchase a home. The term took on significant importance during the 2008 financial crisis, when a rise in default rates on subprime mortgages led to a significant downturn in the housing market and played a large role in triggering the Great Recession.
Explanation
A subprime mortgage is a type of loan given to borrowers presenting a higher risk for lenders, often due to a poor credit history. The purpose of a subprime mortgage is to provide an opportunity for individuals with low credit scores to obtain a home loan, who might not qualify for conventional mortgages. This tier of loans was intended to promote homeownership rates among the underprivileged section of society or those struggling with credit challenges. It allows individuals another chance to improve their credit score while securing their desired home, facilitating the idea of the “American Dream.”Despite bearing a higher risk, subprime mortgages also offer lenders the potential for higher returns. These mortgages come with higher interest rates compared to prime mortgages due to the additional risk involved, making them profitable to lenders. However, it’s important to note that while these loans can be advantageous to both parties if managed properly, they also contributed significantly to the housing bubble and subsequent financial crisis in 2008 due to unsustainable lending practices. Therefore, they should be handled with caution.
Examples
1. The 2008 Financial Crisis: One of the most infamous examples of subprime mortgage impact is the 2008 financial crisis. It occurred when a significant number of homeowners, who had been approved for subprime mortgages they couldn’t afford, began to default on their payments. These defaults ballooned into a housing market crash and a global financial crisis with far-reaching impacts.2. Countrywide Financial: Known for being one of the biggest lenders of subprime mortgages, Countrywide Financial was a major player leading to the 2008 financial crisis. The company targeted borrowers with less-than-stellar credit, offering them mortgages with higher interest rates. However, this led to a high number of defaults, contributing to the company’s eventual collapse.3. New Century Financial Corporation: This was another prominent U.S. subprime mortgage lender that went bankrupt in 2007. The company originally experienced immense growth and success predominantly due to the increased demand for subprime mortgages but was unable to withstand the wave of defaults and foreclosures that followed when the housing bubble burst. In each of these cases, those with subprime mortgages faced increased financial strain as their interest rates climbed, often far beyond what they could reasonably afford. These examples resulted in devastating impacts, not just for the homeowners, but also for the broader economy.
Frequently Asked Questions(FAQ)
What is a subprime mortgage?
A subprime mortgage is a type of mortgage designed for borrowers with poor credit histories. These borrowers may not qualify for conventional mortgages due to their credit score.
Why is it called ‘subprime’?
It is referred to as ‘subprime’ because it is below the ‘prime’ credit rate offered to borrowers with excellent credit scores. These types of loans are considered riskier.
How do subprime mortgages work?
Subprime mortgages work similarly to regular mortgages but usually come with higher interest rates to compensate for the higher risk level. The loan is secured against the borrower’s property and payments are made over a specified period.
What are the risks of subprime mortgages?
The main risk of a subprime mortgage is the higher interest rate, which can lead to larger monthly payments. If the borrower fails to keep up with payments, the lender may foreclose upon the property.
Are subprime mortgages responsible for the 2008 economic crisis?
Yes, to a significant extent. Leading up to the 2008 financial crisis, many lenders provided subprime mortgages to borrowers who couldn’t afford them. The high default rates on these mortgages led to a housing bubble that eventually burst and triggered the crisis.
Who benefits from subprime mortgages?
Subprime mortgages can benefit borrowers with poor credit scores who may not have other options for home ownership. They can also benefit lenders and investors who receive a higher return due to elevated interest rates.
How can I avoid needing a subprime mortgage?
The best way to avoid needing a subprime mortgage is to maintain a good credit score. This can be achieved by consistently making payments on time, reducing existing debt, and not taking on too much new debt.
Can you refinance a subprime mortgage?
Yes, if a borrower’s credit score improves over time, they may be able to refinance the subprime mortgage into a prime mortgage with a lower interest rate.
Related Finance Terms
- Adjustable Rate Mortgages (ARM)
- Foreclosure
- Loan-to-Value Ratio (LTV Ratio)
- Predatory Lending Practices
- Credit Default Swap (CDS)
Sources for More Information
