Subprime Mortgage Definition Types How It Works

Subprime Mortgage Definition

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Types of Subprime Mortgages

Subprime mortgages vary depending on their repayment plan and interest rate characteristics. Owing to the risk involved in these mortgages, the lending bank can choose to offer a repayment plan that works in their best interest. The mortgages can range from 30-50 years, depending on the amount borrowed and the capacity of the borrower to repay.

#1 – Fixed Interest Rate

The fixed interest rate mortgage is offered at a higher rate of interest with a repayment period of up to 40 – 50 years compared to a standard or prime mortgage with a repayment period of 30 years. The longer repayment period enables the borrower to make lower monthly installments and repay the loan in the long-time given.

The lender is happy to lend at a higher rate for a longer period since it guarantees the repayment of the mortgage and an increased return for the actual amount that was initially borrowed.

John is a college pass-out and has just landed a job; he has no prior credit history. He decides to own a home but has limited funds and requires a loan to purchase his dream home. In this case, he can approach a bank for a mortgage loan against the property he wishes to own. The bank can offer a fixed interest rate loan that bears a high interest.

#2 – Adjusted Rate Mortgage Loan (ARM)

An adjusted rate mortgage loan, as the name suggests, has its interest rate adjusted during the tenure of the loan. It is initiated with a fixed rate and later switched to a floating rate.

A 30-year mortgage which is 2 / 28 ARM, means the first two years will bear a fixed interest rate, and the remaining 28 years will bear a floating interest rate. Similarly, a 3 / 28 ARM means the first three years will bear a fixed interest rate, and the remaining will bear a floating interest rate.

#3 – Interest Only Loan

An interest-only loan requires the borrower to pay only the interest for the initial few years of the loan. In this case, the borrowers assume they can fetch a refinance for their property or sell the property before the principal payment starts. This can prove problematic for the borrower since the monthly installments will increase, and the borrower is usually unable to bear the additional burden. Also, if the value of the mortgaged property falls, they cannot qualify for a refinance. They will not have an option to sell the property due to this, resulting in default.

Let’s take John from the above example; after taking an interest-only loan, he wishes to refinance his mortgage without looking at the property’s current market priceMarket PriceMarket price refers to the current price prevailing in the market at which goods, services, or assets are purchased or sold. The price point at which the supply of a commodity matches its demand in the market becomes its market price.read more, which has plunged. As a result, his monthly installments will increase, whereas the value of his property has taken a dip.

Subprime Mortgage Crisis

The Subprime Crisis of 2008 had lost a lasting impact on the global economy, with banks bearing the brunt of the defaulted payments on subprime mortgages. This led to the globe’s recession since all the market participants were impacted directly or indirectly, thereby creating a major impact on business across industries.

Almost 9 million jobs were lost due to the subprime crisis between 2008 and 2009. The subprime crisis is also termed the ‘Housing Bubble’ highlighted by many economists worldwide, focusing on the dark side of the traded mortgage-backed securities.

The subprime mortgages were doing well until 2006 when the mortgaged properties fell. This happened when the interest rates were spiking during that period. As a result, the borrowers could neither sell their property nor refinance their mortgage; moreover, they could not bear the rising installments. Hence, they began to default. This led mortgage-backed securities to plunge in value, resulting in a financial crisisFinancial CrisisThe term “financial crisis” refers to a situation in which the market’s key financial assets experience a sharp decline in market value over a relatively short period of time, or when leading businesses are unable to pay their enormous debt, or when financing institutions face a liquidity crunch and are unable to return money to depositors, all of which cause panic in the capital markets and among investors.read more.

Advantages

It allows individuals with weak or no credit history to obtain a loan at an interest rate than the market rate.Banks and financial institutionsFinancial InstitutionsFinancial institutions refer to those organizations which provide business services and products related to financial or monetary transactions to their clients. Some of these are banks, NBFCs, investment companies, brokerage firms, insurance companies and trust corporations. read more can benefit by providing subprime mortgages since it gives higher returns than prime mortgages.This results in an inflow of funds into the market since the monthly installments paid by the borrower can be used by the banks for different activities, including lending and investing in businesses, thereby making economic movements.

Disadvantages

The risk to reward ratio for subprime mortgages is very high compared to prime mortgages. The higher side is the probability of a subprime mortgage borrower missing a payment or payments or default making any payments.The subprime mortgage crisis that shook the world was due to the excessive lending of such mortgages. The hedge funds that traded in buying and selling these mortgage-backed securities resulted in the crisis.If the borrower defaults to make the payments, the bank has to bear the losses, which creates a rippling effect in the economy.