Over the last few years, there has been a great deal of press coverage regarding subprime mortgages. While in many cases, the accusations about these mortgages is true, there is a lot more to a subprime mortgage than most media outlets have covered. The majority of Americans are not even certain of what subprime mortgages are, they assume they were given primarily to deadbeats by crooked lenders. While there is some particle of truth to this, this fails to tell the whole story that effectively answers the question – what are subprime mortgages.
The simple explanation
The most simplistic explanation of a subprime mortgage is a mortgage loan that is made to a borrower who has a credit score of below 600 and has other risk factors that make them a more risky borrower than those with better credit scores. However, subprime mortgages were made by commercial banks of all sizes, private lenders and by mortgage companies. For several years, subprime mortgages were an attractive option for those who were self-employed or faced other financial challenges.
Remembering the good days
Between 2004 and 2006, mortgage rates were at a lower level than they had been for some time. During this period of time, banks who had stringent lending guidelines loosened their guidelines to consumers who had less than perfect credit. Hence the birth of the subprime mortgage. These mortgages were made at higher interest rates to compensate for the increased risk that the loan presented to the bank.
Credit worthiness was not ignored
It is important to understand that the creditworthiness of borrowers was not always ignored by banks who were involved in subprime mortgages. After all, banks are not in the business of owning real estate, they are in the business of loaning money. However, many borrowers fell into “gray” areas meaning they were recovering from a bad divorce, they were returning to the work force after a long period of unemployment or in some cases, they were self-employed. Typically when these loans were sent to underwriting, these “special circumstances” were taken into consideration.
The role of government
Legislative action between 1977 and 1986 had a significant impact on the availability of subprime mortgages. First, the Community Reinvestment Act of 1977 provided incentives to lenders to loan money to lower-income borrowers. In 1980, the Deregulation and Monetary Control act allowed lenders to make loans at higher interest (not always in the best interest of consumers) based on credit scores. In 1982, the Alternative Mortgage Transaction Parity Act allowed lenders to include balloon payments and adjustable rate loans when offering a mortgage to consumers. Finally, in 1986 the interest deduction which was allowable for consumer loans (cars for examples ) was eliminated but those who paid mortgage interest were allowed the deduction. This occurred with the Tax Reform Act of 1986.
How consumers were taken in
When jobs were not hard to come by and consumers were interested in buying homes versus renting, they were often confronted with credit issues or other challenges that might have made purchasing a home impossible. However, subprime mortgages had their benefits for many of these homeowners. Less stringent underwriting criteria would allow them to get the home of their dreams; the price however may have been too great.
Consumers learned almost immediately that their interest rates would be higher than a more traditional mortgage. In some cases, interest rates could be two to five percentage points higher on subprime mortgages versus a more traditional (or prime) mortgage. For some, this was not necessarily problematic as their earnings were steady. Those homeowners who were fortunate enough to obtain a subprime mortgage with a fixed rate seldom had any surprises. In many cases, these borrowers were able to refinance into a traditional prime mortgage within 24 to 36 months. The problem: Not all (in fact not most) borrowers were placed in fixed rate loans.
The adjustable rate trap
Frequently, subprime mortages came with a built-in problem for borrowers. These borrowers were placed into adjustable rate mortgage (ARM) products that had built in “trigger points” where the interest rates would increase. These mortgages were tied to either the prime lending rate or more commonly, the LIBOR (London Interbank Overnight Rate) and they triggered in some cases as early as six months into the loan. Some loan increases seemed modest, as little as one-quarter of a percentage point. However, when a borrower is paying 12% on a $200,000 mortgage, a 12.5% their monthly payment could increase as much as $78. The problem with this is that many of these borrowers were already stretched too thin.
Even as interest rates came down, borrowers who had an adjustable rate mortgage often found themselves unable to refinance. Borrowers were sometimes told by unscrupulous lenders and mortgage brokers that they could “live” with their adjustable rate loans for 12 to 24 months and refinance their mortgage provided they kept their mortgage payments current. Unfortunately, many of these loans had prepayment penalties that included severe fees if the borrower refinanced, often making this option impossible for them to consider.
Subprime mortgages are beneficial for many borrowers who for various reasons would not qualify for a more traditional prime mortgage. Although banks are less likely to make these types of loans today, a subprime mortgage does have value for a consumer who understands that they are paying higher interest rates (and fees) but who are confident in their financial future. For many, subprime mortgages allowed them to attain their goal of home ownership. For many others, their dream home turned into a nightmare because of subprime mortgages.