Owning your own home—it’s the American dream. Until the last quarter of a century, though, it was a dream beyond the reach of those whose credit scores, for whatever reason, were not good enough to qualify for a mortgage. A person with a lower credit score might be able to secure a home loan with a substantial down payment or a government-backed program, such as a Fannie Mae or VA home loan. In an attempt to make mortgage financing available to consumers with less-than-perfect credit ratings, lenders increasingly offered “subprime” mortgages during the first decade of the 21st century.
Consumers with a credit score above 660 are considered prime borrowers, providing lenders with the least risk of default. A subprime mortgage is a home loan made to a borrower whose credit score is 660 or less. The FDIC (Federal Deposit Insurance Corporation) also designates the following consumers as subprime borrowers:
The interest rate charged on a subprime mortgage is higher than that on a “prime” mortgage. Prime mortgages are customarily tied to the prime lending rate, established by individual banks but typically based on the federal funds rate set by the Federal Reserve. In addition to having a higher interest rate, some subprime loans also extend the term of the loan beyond the standard 15-30 years, in some cases as long as 50 years.
There are a number of different subprime mortgages available:
Just after the turn of the millennium, the number of subprime mortgages escalated dramatically. In an effort to manage the increased risks, lenders and investment bankers created new securities, which pooled some of the high-risk mortgages with other, safer investments, called private-label mortgage-backed securities (PMBS), which they believed would minimize the risk of loss. The explosion of credit pushed up the demand for housing, which in turn elevated housing prices. When subprime borrowers defaulted, the lenders and investors could typically foreclose and sell the property for a profit, thereby managing their risk.
When housing prices peaked, however, and started to fall, many subprime lenders started taking losses on foreclosures, and some were either forced into bankruptcy or stopped making subprime loans. Once the supply of subprime loans decreased, the demand for housing also decreased, which led to lower housing prices. As a result, many subprime borrowers found themselves “under water” on their mortgages, with principal amounts due on their loans that exceeded the market value of the home. The ensuing crisis led to the recession of 2007-2009, the failure of dozens of banks, and the collapse of two of the largest investment banks in the world: Bear Stearns and Lehman Brothers.
Subprime mortgages are still available but have been renamed and repackaged as “nonprime” mortgages or “non-conforming” mortgages. They are, however, subject to significantly more substantial regulation than they were 20 years ago. In 2010, in response to the subprime mortgage crisis, Congress enacted the Dodd-Frank Act, which imposes on lenders an ability-to-pay (ATP) rule. Before making a loan, a lender must undergo an extensive evaluation process to confirm that the borrower has the resources to repay the loan. Subprime borrowers must also complete homebuyer counseling before receiving financing. The Consumer Financial Protection Bureau, an agency of the United States government, also provides resources for both mortgage professionals and homebuyers, helping to minimize the risks involved with nonprime lending.
Prospective homeowners whose credit scores are not high enough to secure lending at the prime rate may qualify for a “subprime” or “nonprime” mortgage loan. Subprime loans typically carry a higher interest rate and may have a longer payoff term. Because subprime loans carry greater risk, they have the potential for abuse. In the first decade of the 21st century, the availability of subprime mortgages exploded, causing an escalation in housing prices and an eventual collapse, which led to numerous commercial and investment bank failures. Federal legislation enacted after that collapse now provides greater protections to consumers and lenders.
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