Sunday, December 17

Banking Terms–Subprime Mortgage

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Banking Terms—Subprime Mortgage

When a person applies for a home mortgage, the lender checks his credit score, income, payment history, and employment history. Anybody who does not have stellar qualifications in all of these categories will not qualify for the best rate on a loan. For example, a good job with a very good income is definitely a plus, but not if you have only had that job two months, and before that you worked as a janitor for minimum wage. In earlier times, anybody who did not qualify did not get his loan application approved.

However, a few years ago, interest rates were low and banks had a lot of capital available, so they started approving loans to people who previously would not have qualified. The banks were assuming a higher risk, so they believed they were justified in charging a higher rate. They offered loans at rates substantially higher than that given to prime borrowers. They came up with a truly insidious device called an adjustable rate mortgage (ARM). Initially, the loan would have a low rate of interest. After a fixed number of years, the interest rate would change, usually to a floating rate based on an index. That meant mortgage payments would rise, often dramatically. If the person’s income had also increased substantially, they could then make the higher payments. However, if they had not experienced a rise in income, they might not be able to make the new payments.

Subprime loans gave the banks a higher return because of the higher interest rates. The housing market was booming, with prices rising every year. The banks (and those who obtained these loans) figured if their client could not meet the payments, the house could be sold for more than the original selling price, so the bank would still get paid. The bottom fell out of the housing market, home prices dropped, and those who had obtained subprime mortgages could not make their payments. Many houses were not worth the outstanding amount of the loan, so the homes could not be sold for enough to cover the loan. 

The loan was called “subprime” because the applicant did not qualify for the prime rate. The housing bubble burst, and homeowners and banks floundered. Many had to file bankruptcy.

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