What Are Subprime Mortgage Loans?
Subprime mortgage loans are a class of mortgage loans. When a bank makes a prime mortgage loan, it considers the home buyer a good credit risk, so it charges the home buyer a lower interest rate on the mortgage. A bank offers a subprime loan to a customer who does not meet the requirements for a prime loan, such as a high credit score or a larger down payment.
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Loan Purchase
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In many cases, subprime mortgage loans are not good investment choices for a bank. The higher interest rate that the bank charges for the subprime loan does not always make up for the increase in default risk when the bank makes a riskier home loan. To reduce the bank's risk so that it can profitably make a subprime loan, the government agency known as the Federal Nation Mortgage Association, or Fannie Mae, enters into contracts with banks to purchase subprime mortgages that a bank no longer wants to hold.
Credit Score
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When a bank decides to make a subprime mortgage loan, it considers the buyer's credit history. One major credit assessment that a bank uses to judge risk is the Fair Isaac Mortgage Score, which the Fair Isaac Corporation provides. The Fair Isaac Corporation is a private company that rates the creditworthiness of a prospective home buyer. This score includes information that other credit reporting agencies, such as Equifax, report to the Fair Isaac Corporation.
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Loan to Value
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A bank also uses the loan-to-value ratio when deciding to issue a subprime mortgage loan. The contract terms of a prime mortgage often require the buyer to provide as much as a 20 percent down payment of the home's value. When a buyer does not have enough cash to meet the down payment requirement, the bank will not give the buyer a prime loan, but the bank may be willing to provide a subprime mortgage loan.
Adjustable Interest Rate
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The University of North Carolina states that 80 percent of recent subprime mortgage loans include an adjustable interest rate. An adjustable interest rate mortgage can be easier for a low income buyer to afford at first, if the initial interest rate is low. This is especially important when the buyer is already paying additional interest charges because of the extra risk a bank takes on when it makes a subprime loan. An adjustable interest rate can increase, raising the mortgage payment to a level which a low income buyer cannot afford.
Speculation
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Since subprime mortgage loans do not have the same down payment requirements as prime loans, many investors purchase property using these loans to speculate on an increase in home prices.The speculator expects the homes to rapidly increase in price and may need to sell several houses at the same time if house prices drop. This situation can cause a rapid decline of home prices since many speculators are selling houses at the same time.
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References
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