A mortgage loan is classified as either prime or subprime depending on the credit risk of the borrower. Interest rates are higher on subprime mortgages, reflecting the higher credit risk (Sengupta & Emmons, 2007). The American policy of encouraging home ownership eventually necessitated making the financing of home purchases as simple as possible. Fannie Mae began demanding that lending institutions prove that they were not refusing to finance home purchases in neighborhoods considered high risk even if the prospective borrowers were good credit risks. This resulted in lending institutions lowering lending standards. With interest rates low and the easing of lending standards people were able to borrow more money. The skyrocketing values of property increased home owners’ equity. Many homeowners refinanced and took second mortgages using this equity. Banks offered easy access to money, and people were able to obtained high risk mortgages such as option-ARMs (Pritchard, n.d.). Many with poor credit ratings or with little or no documentation qualified as subprime borrowers (Pritchard, n.d.). A sharp rise in home foreclosures in 2006 mushroomed out of control in 2007 and triggered a national financial crisis that went global within a year (Allen & Carletti, 2010). The majority of the mortgage loan defaults were subprime loans. Banks and investors began losing money with the increase of homeowners defaulting on loans. To reduce risk banks began to show reluctance to lend. Eventually bank weaknesses became bank failure (Pritchard, n.d.).
Risks to Borrowers and Lenders
Subprime borrowers typically are persons that have a poor credit history or have a high a debt to income ratio. The interest rates on subprime loans are higher and this may increase the risk of the borrower defaulting on the loan, which often results in foreclosure. A great deal of subprime borrowers found that they owed more than their homes were worth once the housing bubble caused a decrease in property values, and many let the lender foreclose on their properties. Lenders of subprime loans increase their risk because of the higher possibility of borrowers defaulting. A high default rates increases monetary losses placing the lender at risk for going out of business.
ALLEN, F., & CARLETTI, E. (2010). An Overview of the Crisis: Causes, Consequences, and Solutions &ast. International Review of Finance. doi:10.1111/j.1468-2443.2009.01103.x
Pritchard, J. (n.d.). What Caused the Mortgage Crisis? [Web log post]. Retrieved from http://banking.about.com/od/mortgages/a/mortgagecrisis.htm
Sengupta, R., & Emmons, W. R. (2007). What is subprime lending?