Sub-prime lending is characterised by high interest rates, negative credit record and poor quality collateral. This type of loan is apt for individuals who cannot borrow loan by tradition lending options due to bad credit score generally below 650 or having a limited asset or income. But this involves some risks also. So one should wisely opt for this type of lending option.
Sub-prime lending getting on the popularity charts
There was a time when the realty was on boom. Everyone was looking to invest in the real estate no matter what their financials were and they were ready to take any amount of risk even if they were not capable of handling the repayments for as long as the term of the loan. A lot of people took loan with a view that they would sell the property once it appreciates in value within a time span of 2-3 years and till that time they would hold on to it at prlog.org.
Banks and the other lending institutions too were keen on making hefty profits. They were of the opinion that the sub-prime lending would offer them more than the expected returns. Firstly they would gain from the higher interest rates which were levied on the loans owing to the high risks involved in the loans. Secondly, knowing that the borrowers are not with a great financial status there are chances that they might not be able to make the payments and the banks would gain by selling the property at higher value and will earn great profits. However, a lot of borrowers were seen failing to pay their mortgages immediately after a period of just one year. With this a series of events triggered and there were more sellers in the market willing to sell their property at lower rates than the buyers. This resulted in the crash in the property market and resulted in the crisis. Banks and the financial institutions in the business of lending saw major losses and could not get rid of their reposed properties.
Understanding sub-prime loans
Loans which are offered to individuals with limited credit sore or to those who are unable to qualify for prime loans are known as sub-prime loans. These loans generally have higher interest rates than prime loans. These higher rates are due to poor credit record of the borrower as lenders have less faith in these borrowers.
Factors like assets, credit rating and income decide whether an individual is qualified for a loan. So a poor credit rating or an inability to prove income can lead to disqualification for a loan hence these individuals opt for a sub-prime loan with high interest rates.
Comparison between prime and sub-prime loans
• Sub-prime loans have a high interest rate on loan borrowed than prime loans.
• Sub-prime loans also have high charges and fee than prime loan.
• Sub-prime loans differ from lender to lender while prime loans often remain similar to all lenders.
• Sub-prime loans are generally used for financing mortgages whereas prime loans can also be used for car loans, personal loans.
• One has to pay increased monthly payments in sub-prime loans for the same amount borrowed in prime loans.
The terminology “subprime” is rarely used by lenders as it is not an attractive term in lending business. So borrowers generally don’t realize that they are borrowing a sub-prime loan.
Strong incentive to loan money to low-income borrowers was granted to lenders due to community reinvestment act of 1977 and later liberalization of regulations. In addition to this, loans with no credit check lenders were allowed to charge high interest rates to borrowers who have poor credit rating by passing Deregulation and Monetary Control Act of 1980. In 1982, use of variable rate loans and balloon payments were also allowed due to Alternative Mortgage Transaction Parity Act. All these acts started a fierce attack of sub-prime lending.
As time passed, sub-prime lending began to expand as businesses realized the need to adapt with the changing times. Most consumers chose sub-prime loans for mortgages although these loans can be used for making a variety of purchases. So with passing time, sub-prime loans shifted more towards mortgage market. During the period of 1994 to 2003, an increase at a rate of 25% per year was recorded in sub-prime lending by the Federal Reserve Board in 2004 which is the fastest growing segment of the U.S. mortgage industry.
Advantage of sub-prime loans
According to the Federal Reserve, in less than a decade, sub-prime loans have helped to tens of millions of households in becoming homeowners. Hence these loans have created more opportunity for homeownership than any other type of loan. Due to these sub-prime loans, America is now among top tier of developed countries in relation to homeownership rates. It is at par with United Kingdom but lags just behind Spain, Finland, Ireland and Australia. As owning a home is best way in building wealth, so home equity acts as the main source for primary savings for a major percentage of American population.
Drawbacks of sub-prime loans
Generally sub-prime loans are quite expensive and have high interest rates. In addition to this, they are also accompanied by prepayment and other penalties. So the final payment can rise abnormally in sub-prime loan due to high interest rates, penalties and other miscellaneous charges. This type of loan is often considered by the borrowers who have no other means of collecting funds and don’t have basic knowledge of loan mechanism.
For lenders, this can increase sloppy business practices as in order to establish new business, they could offer loans without checking borrower’s capacity in making repayments. They could lend money without asking the borrower for providing documented proof of income and without knowing the borrower’s ability to cope up with rising interest rates.
Worst case scenario involving sub-prime loans
Since prime loans cannot be taken by individuals having low income or poor credit score, they opt for a sub-prime loan. Due to this reason defaulter rate will be high in sub-prime loan than in prime loan. In a situation when property rates tend to fall and interest rates increase rapidly, whole economy will be affected.
Borrowers can become defaulter if they are unable to make their repayments or refinance. Lenders can incorporate loss when foreclosure rates will tend to rise. So if the loan becomes default, investors who purchased equity backed securities will also bear loss.
Sub-prime loans can prove to be a valuable tool in giving the power of purchasing to the individuals who does not have enough funds. But this tool should be used responsibly otherwise this can have a very devastating effect. Both borrowers and lenders are responsible for the negative image of sub-prime loans in mortgage industry. But as borrowers are the one who suffer the most so they should be extra careful in dealing with this type of loan. If they know that they cannot repay the loan borrowed, they should not sign the loan papers. It is the borrower who makes the choice of opting for a loan so he should have full understanding of consequences. No loan is good or bad; one should be clear on what he wants and chose wisely.