Sub Prime Mortgage Explanation
The subprime mortgage crisis is an ongoing real estate and financial crisis triggered by a dramatic rise in mortgage delinquencies and foreclosures in the United States. It has had major adverse consequences for banks and financial markets around the globe. After U.S. house prices peaked in mid-2006 and began a steep decline thereafter, refinancing became more difficult. As adjustable-rate mortgages began to reset at higher rates, mortgage delinquencies soared.
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Features
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Subprime lending is a term used to describe lending to people whose credit report categorizes them as high-risk borrowers. While the actual credit score delineating prime from subprime differs according to the lender, it is usually in the area of 600. Other categories contribute to this rating, including the size and structure of the loan itself and documentation on the loans that does not meet the underwriting guidelines of Fannie Mae or Freddie Mac.
Why It Worked
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At first glance, it's hard to see why any lending institution would want to lend money to high-risk borrowers. The reason is simple, though: These types of loans were extremely profitable to everyone involved. Mortgage brokers made money by selling the loans, underwriters involved in breaking up the loans into individual investment opportunities got paid, and the borrowers themselves were happy to buy a house they could never have otherwise afforded.
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Types
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There are many different types of subprime mortgage loans, used in various situations by competing lenders. The most popular is known as an adjustable-rate mortgage. These loans are presented to borrowers by offering them a low fixed interest rate at the beginning of the loan. Written into the terms is a specific point when the interest rate will increase, using a floating rate index.
The Crash
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It was the use of these adjustable-rate mortgages that led directly to the credit crisis that began in late 2006. Borrowers took the loans, either confused by the concept of a rising interest rate or confident their financial situation would improve by that time. When the rates went up, however, many families were unprepared and thousands of homes went into foreclosure.
Prime Borrowers
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People with bad credit weren't the only ones affected by the mortgage crisis. Because these subprime lenders were extremely efficient at marketing their loans, many prime borrowers got caught up in these mortgages as well. Sometimes they assumed this was the best deal they could get, perhaps after being turned down by a single prime lender for some reason. These prime borrowers may not have been forced to default in as many instances, but many were still stuck with unfavorable terms as the real estate market tanked.
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