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Subprime loans

From lawbrain.com

Home loans made available to borrowers with below prime credit ratings are called subprime loans. Lenders look to the borrower's assets, income and credit scores when ascertaining the risk of the borrower defaulting on the loan. A borrower who poses a risk of defaulting on the loan might still be offered a loan, but at a higher interest rate based on a risk-based pricing model.[1]

During the housing market boom of 2004-2006, lenders would take the potential appreciation of the value of a home into account when making the subprime loan. In addition, the lender's costs from a potential default were also offset by higher interest rates and other loan conditions. Thus, even homeowners with a question mark against one of their loan qualification factors(no assets, unverifiable income and/or sub-620 FICA credit score) qualified for home loans, but at a higher interest rate than prime and with other non-standard loan conditions. Some of the loan conditions included:

  • prepayment penalties so that it was hard for the borrower to repay the loan or refinance it prior to its pay-off date;
  • a balloon payment at maturity, i.e., a large payment due from the borrower as a final payment; and
  • low introductory rates that steeply increased after the initial period, resulting in monthly payments that were almost 50% higher than the initial monthly payments.

Many homeowners with subprime loans were soon unable to meet their financial obligations to the lender. In aggregate this financial distress of subprime mortgagors signalled the advent of the mortgage crisis that eventually led to the bankruptcy of many institutions transacting in derivatives securitized by these mortgages.

Further Reading

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  1. Lisa Smith, Subprime Lending: Helping Hand Or Underhanded?, Investopedia, A Forbes Digital Company. http://www.investopedia.com/articles/basics/07/subprime_basics.asp


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