15 Jun Mortgage Basics: What Is A Sub Prime Loan?
A sub prime loan refers to the mortgage written for a person with less than perfect credit. In the lending business, risk of loss is balanced by the interest rates and fees charged to the borrower. A lender offers a higher risk loan to a borrower who presents a greater chance of default. Twenty years ago lenders offered low interest rates fixed over the duration of the loan to borrowers with 20 per cent down payments or equity in the property. The rates increased for borrowers with 15 or 10 per cent equity respectively.
In an effort to serve the segment of borrowers without equity, the lending industry began offering various types of loans that adjusted with market conditions. As prime lending rates increased, the adjustable rate mortgage would reset to a higher interest rate, resulting in a higher monthly payment.
The lower the interest rate, the lower the monthly payment. This allowed many home buyers to obtain financing for little or no money down loans tied to the prime lending rate, plus a few points to compensate for the increased risk. As the segment grew, lenders began offering less than prime interest adjustable rate loans. These lower interest rates, known as teaser rates, enticed borrowers to sign up for mortgages based on the lower monthly payment. My colleague Brett Weiss discusses a type of loan based on the 2/28 structure in What is a 2/28 Mortgage and is it a Bad Thing? Other loans come in a 3/27 variety. Each type results in an adjustment of the monthly payment every 6 to 12 months as the mortgage rate is reset after the first 2 or 3 year low interest teaser rate expires.
Borrowers who relied on the initial monthly payment face difficulty making the higher payment when the rate adjusts in an upward spiral. Also see Chip Parker’s How the Subprime Scam Works.
Andy Miofsky, Esq.
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