What is a subprime loan? Subprime loans are unconventional loans designed to put as many people as possible in a home or to refinance an existing home regardless of the borrowers’ credit history. A subprime loan allows lenders to make loans whether or not the borrower has poor credit, no credit or even a very low Fair Isaac Corporation (FICO) score. Basically, subprime loans are creative ways to convenience someone that they can afford more than they should.
Listed below are just some examples of subprime loans.
1. Fixed Rate Mortgage (FRM). A FRM has a fixed rate mortgage but the borrower usually has a much higher interest rate than a person with good credit.
2. Adjustable Rate Mortgages (ARM). As the interest rate varies, so does a borrowers monthly payment.
3. Hybrid ARM. This is typically a FRM for x number of years at a fixed rate, and then it changes to an ARM. 2/28 is a very common term for this type of loan.
4. Negatively Amortizing Mortgages (NegAms). These are loans where the borrower pays back less then the full amount of the interest for x number of years and the differences is added back to the principle.
5. Interest-Only (IO). An ARM or FRM where the borrower only pays back interest for a set time. After that the borrower than pays back the interest and principle.
Subprime loans have been around since the 80’s when only about 5% of all mortgages were subprime. By 2005, almost 20% of all loan originations were subprime. With more than $1.3 trillion dollars in subprime loans outstanding, there are global ramifications if borrowers start defaulting. Because of the inherent risk involved with borrowers that have poor credit, mortgage lenders need to have a reserve to cover loans incase they end up in default.
Before the mortgage crisis, many lenders only had loan allowance of less than 1% of the net loans. As
Bibliography: Dr. Porter, Thomas L, Dr. Chanysheve, Airat. (2007), “The Subprime Meltdown: Understanding Accounting-Related Allegations”, <http://www.mmc.com/knowledgecenter/SubprimeMeltdown_AccountingAllegations.pdf> Crowe Chizek and Company, (2008), “Litigation Update: Subprime Accounting and Disclosure Issues Draw Scrutiny”, <http://www.mmc.com/knowledgecenter/SubprimeMeltdown_AccountingAllegations.pdf> NPR, (2007), “Disclosure Rules Fail Some in Subprime Market”