What is a Subprime Mortgage?

//What is a Subprime Mortgage?
What is a Subprime Mortgage? 2017-10-10T08:05:41+00:00

Definition: A subprime mortgage is a home loan that is given to applicants with a poor credit history who typically do not qualify for traditional mortgages.

What Does Subprime Mortgage Mean?

What is the definition of subprime mortgages? Since these loans are extremely risky for the lender, they typically carry an interest rate higher than the prime rate. Hence the name.

These mortgages rely on the somewhat controversial and highly questionable practices of allowing those with extremely poor credit ratings to receive mortgages. However, the catch is that these mortgages typically have very high interest rates that are usually adjustable. This is where much of the controversy lies. Many sub prime mortgages entice customers with interest rates that are initially very low and then after a period of time, like a year for instance, the interest rate will soar upward and the mortgage payments increase exponentially.

Usually, sub prime mortgages have absolutely nothing to do with business. However, in the years leading up to the collapse of the housing industry in 2008, many businesses began selling mortgage backed securities that sometimes contained sub-prime mortgages. Mortgage-backed securities are not a new invention, but the inclusion of sub-prime mortgages in these securities was a new idea.

The issue that stemmed from this practice was that the risk of default in these loans was significantly higher than that of other mortgage-backed securities because the borrowers weren’t very likely to keep making payments. As we all know, many borrowers ended up defaulting on the loans, which essentially cost investors billions of dollars.

Let’s take a look at an example.

Example

John is seeking a loan for a house that he is interested in buying. However, John does not have a very good credit history and has frequently defaulted or been delinquent on payments for his loans in the past. As a result, John’s credit score is extremely low. Therefore, John won’t get approved for a traditional loan. He must apply for a sub-prime one.

After receiving said loan, John’s monthly payment was only $300, which was affordable for John. However, after a period of 12 months, the prime rate increased and John’s floating interest rate loan also jumped. Now his monthly payment is $1,000 per month. Unfortunately, the payment became too much for John to pay and he was forced to default on his loan.

Summary Definition

Define Subprime Mortgages: Sub-Prime mortgage means a loan to purchase a home made available to people with a credit rating of less than 600 who couldn’t otherwise quality for a traditional, private mortgage.