What is a sub prime loan? Sub-prime loans are loans made to borrowers generally considered a less than an ideal credit risk. These potential borrowers usually have a credit score of 620 or less on a scale of 300-850. These types of loans were created to satisfy a mortgage market that consists of about 20 percent of the potential mortgage loan seekers. This allowed lenders to loan money to those borrowers who normally would not qualify for a home loan.
Why would mortgage lenders want to do this?
Partly because of the Community Reinvestment Act (CRA) signed into law in 1977. This act strongly suggested and maybe even required lenders such as commercial banks and S&L lenders to make loans available to all quarters of the community, including low and mid income borrowers. CRA does not require compliance per say...however, an institution's CRA compliance record is taken into account by the banking regulatory agencies when the institution seeks to expand through merger, acquisition or branching. A kind of behind the scenes arm-twisting. (i.e. if you want to do this you will do this)
CRA activities were expected to be carried out within the normal guidelines of safe and sound banking practices. These safe and sound practices were stretched to the limit and beyond by institutions greedy to enter this new found credit market.
What's the problem with sub-prime loans?
First of all borrowers were encouraged to purchase homes beyond their means. Lenders often loaned all the money necessary to close the sale. Including down payment and money to pay all closing costs. Secondly, about 80 per cent of these loans had an adjustable interest rate or ARM (adjustable rate mortgage)
Adjustable rate mortgages usually begin with a lower rate, often several points lower, than a normal fixed rate mortgage. This lulls the borrower into thinking everything is Ok and he can make payments easily. Then after several years the ARM kicks in and suddenly payments are increased beyond what can be made. This sets the loan up for default and default they have by the hundreds of thousands.
Additionally, owners have often refinanced homes to pay off credit cards and other very high interest rate loans. Most of these loans were insufficient to solve the borrowers financial problems or they immediately began to run up additional credit card bills. Financial institutions were very eager to comply as long as real estate values continued to climb...also, mortgage brokers are paid to write up loans and are not penalized if the loan fails.
In conclusion, the whole problem boils down to shady and greedy lending practices and government interference with proven safe and sound lending guidelines. The way back up won't be easy and it will take a while and lets hope we never return to sub prime lending.
