Introduction to Subprime Loans
Subprime loans are loans offered to individuals at a higher rate above prime rate who do not qualify for prime rate loans either because of lower credit rating assigned to them, low income, high loan to value ratio or other factors which indicates that they will default on their debt obligation. The investors in traces created from subprime mortgage loans have no guarantee in interest and principal repayment.
Lenders generally offer Subprime loans when the borrower fits into the below criteria:
- Lower FICO scores, i.e. below 660
- Higher debt to income ratio
- Higher debt to asset ratio
- Foreclosure in last 24 months
- Near to bankruptcy
- Greater obligation such as living expenses, children expenses, education expenses
Reasons for Subprime Loan Crises in 2007-2008
Reasons for Subprime Loan Crises in 2007-2008 are given below:
The main Driver was Profit Making
Their knowledge influenced the behaviour of mortgage originators that mortgagees will be securitized. When considering new mortgage applicants, the main driver was not a credit rating assigned to these investors; rather, it was whether it could fetch huge money.
Lack of Tools Available to Assess Credit Rating
when mortgages were securitized, the only information about the mortgages by the buyers of the products that were created from them was a loan to value ratio (the ratio of the size of the loan to the assessed value of a house) and the borrower’s FICO ratio. Other information on the mortgage application form was considered irrelevant and often not even checked by lenders. The lender’s most important thing was whether the mortgage could be sold to others, which depended largely on the loan to value ratio and the applicants’ FICO score.
No Independence to Property Assessors
Subprime loans were mostly backed by house property. Passing both loans to value ratio and FICO score was doubtful quality. The property assessors who determined the value of the house at the time of the mortgage application were pressurised by lenders to come with high value. Potential borrowers were sometimes counselled to take actions that would improve their FICO scores.
Regulatory Requirements were Relaxed
US government had since 1990 been trying to expand homeownership and had been applying pressure to mortgage lenders to increase loans to low- and moderate-income people, which lead to a drastic increase in subprime loans.
Fake Application Forms
One of the terms used to describe subprime loans was liar loans because individuals applying for loans were aware that no checks would be carried out and hence chose to lie on the application form.
Lack of Knowledge to Rating Agencies
Rating agencies have moved from the traditional form of bond rating to structured products that are highly dependent on default correlation between the underlying asset, which was relatively new and little historical data was available.
Lack of Knowledge to Investor
The product bought by investors was complex, and both investors and rating agencies have incomplete and inaccurate information about the quality of underlying assets.
Risks Involved in Subprime Loans
Subprime loans carry greater risks as compared to other conventional loans. There is a lower probability of capital repayment by the borrower, and hence lenders charge higher interest rates to compensate for higher risks. On the other hand, the borrower has more probability of default if additional fees and interest are levied.
Higher Fees Levied
Origination fees and upfront service charges are significantly higher in subprime loans as compared to conventional loans. Lenders often charge these rates in the form of higher monthly instalments. Late payment fees are also higher.
Difference Between Prime Loan and Subprime Loan
The difference between Prime Loan and Subprime Loan are as follows:
- The federal reserve bank decides interest on the prime loan, i.e. fed funds rate the rate at which renowned banks borrow and lend from each other, which are fixed in nature. However, subprime loans vary as per the attributes of different lenders.
- Subprime loans are often taken on auto loans, home loans, education loans, revolving loans, personal loans and small-scale business loans, which are very risky in nature as compared to prime loans, which are taken by large financial institutions, big corporates with higher credit rating.
- Subprime borrowers do not have strong credits histories, which include loan defaults, lack of possession of asset or property which can be used as collateral, they have been a record of missed payments on credit cards or other existing loans or an outstanding legal judgement against the individual whereas Prime loans have stronger financial status.
Type of Subprime Loans
Here we discuss the type of Subprime Loans :
1. Adjustable Interest Rates
These interest rates increase gradually over the course of the repayment period, i.e. they have a fixed interest rate at the beginning but later on, changed to floating. For e.g. 2/28, wherein the fixed rate is chargeable for the first two years and after the initial two years, the rate will be variable. However, there are loans in which the interest rate will decay over a period of time. These are normally provided to an investor who is facing financial problems in the short term but may be profitable in the long term.
2. Fixed-Rate Loans
This type of loan has a longer repayment period which may vary from 30 to 40 years. Due to the longer maturity, the involved interest rate is higher and fixed with low monthly instalments.
3. Interest-only Subprime Loans
In this type of loan, interest payments and principal payments are divided into different periods. For e.g. in a 30-year repayment schedule borrower will pay the interest portion in the first 10 years thereafter, he will start paying the principal amount of the loan. It is useful for borrowers with fluctuating earnings.
4. Dignity Subprime Loans
in this type of loan, a small down payment is required, which may vary from 2-5% of the total principal amount; after that, the borrower has to pay instalments at a higher interest rate on the remaining principal value. If the borrower does not miss any instalments, then the interest applies on the balance loan may decrease over time to be equal to the prime rate.
Many financial institutions do not provide Subprime loans due to an extra layer of credit risks involved in the event of default, thereby increasing the interest rates chargeable on these loans. But however, just increasing the interest rate won’t solve the problem as it may put more financial pressure on the borrower.
This is a guide to Subprime Loans. Here we discuss the introduction and difference between a prime loan and a subprime loan, along with the type of subprime loans. You can also go through our other suggested articles to learn more –