Mar 24th, 2008
Working Backwards: What’s Subprime?
The term subprime refers to borrowers who have issues with their credit history. The credit rating and history of the borrower is what is subprime (meaning poor or non-existent), rather than the interest rate of the loans given to subprime borrowers, which are higher than typical. Subprime loans also carry more risk for both the borrower and the lender. The lender is lending money to a borrower who has not demonstrated through a healthy, verified credit history the ability and willingness to repay the loan, justifying the higher interest rates–just as a higher return is expected in investing for taking more risk, a higher rate on the loan is expected for the lender taking more risk. The borrower takes a higher risk of defaulting as the payments are higher and they have not demonstrated a history of being a good credit risk. While subprime lenders offer loans to those who would otherwise not be able to borrow enough money to, for example, purchase a house, the unfortunate downside of subprime is that many borrowers are unable to repay the loans.
In regards to the current subprime mortgage crisis, a subprime borrower would often take on an adjustable rate mortgage that usually starts with a low “teaser” interest rate for a few years then resets; combine this with a rise in interest rates over the past few years (prior to the last six months) and the subprime mortgage borrower often ended up unable to pay their mortgage, leading to defaults and foreclosures.
The subprime crisis is not yet over–it led to the fall of Bear Sterns last week and it is not yet known what effect it will have going forward. The lesson to learn from subprime is this: in terms of dealing with bonds, buy quality; build a healthy credit history so you do not have to engage in a subprime loan; and only borrow what you can afford. The next few months will tell us just how extensive the damage due to subprime has been.
[...] has been made of the disaster known as subprime mortgages; we’ve looked at what subprime means before, and recently Debt Free looked at The ARM: What [...]