Definition
A subprime mortgage is a type of home loan issued to borrowers with low credit ratings. These borrowers typically do not qualify for conventional loans due to their poor credit quality, inability to provide sufficient documentation, or unstable income histories. Subprime mortgages come with higher interest rates to compensate for the increased risk of default. Despite not meeting the lending standards of Fannie Mae and Freddie Mac, these loans were widely securitized and sold on the secondary market by investment banks, significantly contributing to the real estate crisis of 2006.
Examples
- A borrower with a credit score below 620: This individual secures a mortgage with a 7% interest rate due to their poor credit history and past financial difficulties.
- No-Documentation Loan: A self-employed person with inconsistent monthly income is granted a subprime mortgage without the usual documentation of income and employment.
- Adjustable-Rate Subprime Mortgage: An individual takes out a loan with a low initial interest rate that can increase substantially over time, leading to potential payment difficulties.
Frequently Asked Questions (FAQs)
Q1: What is the general threshold for a credit score considered ‘subprime’? A1: A credit score below 620 is commonly considered subprime.
Q2: Why do subprime mortgages have higher interest rates? A2: Lenders charge higher interest rates on subprime loans to offset the higher risk of default associated with borrowers with poor credit histories.
Q3: How did subprime mortgages contribute to the 2006 real estate crisis? A3: Banks securitized and sold large volumes of subprime mortgages, encouraging risky lending practices and leading to widespread defaults when housing prices fell, which eventually triggered the financial crisis.
Q4: What is a no-documentation loan? A4: A no-documentation loan, often offered as a subprime mortgage, does not require extensive proof of income, employment, or assets, appealing to borrowers with inconsistent or unverifiable income sources.
Q5: Are subprime mortgages still available today? A5: Yes, but they are subject to stricter regulations and disclosure requirements to prevent the types of abuse seen before the financial crisis.
Related Terms
- Fannie Mae: A government-sponsored enterprise (GSE) that expands the secondary mortgage market by securitizing mortgages in the form of mortgage-backed securities.
- Freddie Mac: Another GSE similar to Fannie Mae, it buys mortgages from lenders to pool them and sell them as securities.
- Mortgage-Backed Securities (MBS): Financial instruments composed of a bundle of home loans bought from the banks that issued them.
- No-Documentation Loan: A loan that requires little or no documentation of the borrower’s income or financial situation.
Online References
Suggested Books for Further Reading
- “The Subprime Solution: How Today’s Global Financial Crisis Happened, and What to Do about It” by Robert J. Shiller
- “The Financial Crisis Inquiry Report: Final Report of the National Commission on the Causes of the Financial and Economic Crisis in the United States” by Financial Crisis Inquiry Commission
- “The Big Short: Inside the Doomsday Machine” by Michael Lewis
Fundamentals of Subprime Mortgages: Real Estate and Finance Basics Quiz
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