Subprime Mortgage
A subprime mortgage is one that’s normally issued to borrowers with low credit ratings. A prime conventional mortgage isn’t offered, because the lender views the borrower as having a greater-than-average risk of defaulting on the loan.Lending institutions often charge interest on subprime mortgages at a much higher rate than on prime mortgages to compensate for carrying more risk. These are often adjustable-rate mortgages (ARMs) as well, so the interest rate can potentially increase at specified points in time.
Definition: Subprime mortgages are loans granted to borrowers with lower credit ratings. Because these borrowers are considered to have a higher risk of default, financial institutions typically do not offer mainstream conventional mortgages to them. To compensate for the higher risk, financial institutions usually charge higher interest rates on subprime mortgages. These loans are often adjustable-rate mortgages (ARMs), meaning the interest rate may increase at specific points in time.
Origin: The concept of subprime mortgages originated in the late 1990s and early 2000s when financial institutions began offering loans to borrowers with lower credit ratings to expand their market share. The subprime mortgage market rapidly expanded in the mid-2000s, eventually leading to the global financial crisis of 2007-2008.
Categories and Characteristics: Subprime mortgages are mainly divided into two categories: fixed-rate subprime mortgages and adjustable-rate subprime mortgages (ARMs).
- Fixed-Rate Subprime Mortgages: The interest rate remains constant throughout the loan term, and the borrower pays the same amount each month. The advantage is rate stability, but the initial rate is higher.
- Adjustable-Rate Subprime Mortgages (ARMs): The interest rate may adjust at specific points in time, usually starting lower in the initial years but potentially increasing later. The advantage is a lower initial rate, but the disadvantage is future rate uncertainty, which may increase the borrower's repayment pressure.
Specific Cases:
- Case 1: Mr. Wang has a low credit score and cannot obtain a conventional mortgage. He opts for an adjustable-rate subprime mortgage with an initial rate of 3%, which rises to 5% after two years. Although the initial repayment pressure is low, the increased rate later adds financial stress.
- Case 2: Mr. Li has a low credit score but urgently needs to buy a house. He chooses a fixed-rate subprime mortgage with a rate of 6%. Although the rate is high, the monthly repayment amount is fixed, avoiding the uncertainty of rate fluctuations.
Common Questions:
- Question 1: Why are the interest rates on subprime mortgages higher?
Answer: Because the borrower's credit score is lower, the risk of default is higher, and financial institutions compensate for this risk with higher interest rates. - Question 2: Will the interest rate on an adjustable-rate subprime mortgage always increase?
Answer: Not necessarily. Rate adjustments depend on market rates and specific terms in the loan contract, but they typically may increase after the initial years.
