Subprime loans are loans offered to people who otherwise would not be able to afford a loan. People who are credit worthy are those who have a demonstrated ability to pay back the loan. Subprime borrowers are those who would be turned away by conventional lenders because their credit rating pointed to a reasonable probability that the loan would not be repaid, but would end in default.
Those who need to borrow are those who lack the capital to achieve some goal. In the case of subprime loans, in recent decades in the United States, a very common goal was home ownership. However, other types of subprime credit were granted for a number of reasons by lenders. While lenders who give the largest loans are banks for home ownership, many credit companies lend for the purchase of automobiles. These are the two largest purchases made by most people. Also, many companies including well-known brands of clothing, jewelry, and other consumer goods have created credit companies or joined with them to make subprime loans to keep sales flowing.
The interest rate on subprime loans is usually higher than traditional loans, making them more expensive for those getting the loan. Such loans are usually to people with limited or small incomes. The higher interest charged meant that the cost of the loan increased by thousands of dollars over the life of the loan. In addition, to make the loan affordable in terms of monthly payments for paying the interest and principal, the life of the loan was usually longer, thus also adding to the cost of the loan.
Getting a subprime loan for those with limited means may have been their only realistic option for getting a credit card, consumer loan, or home mortgage. Even with a higher interest rate, it was possible to get credit at a subprime rate to repair a bad credit rating due to unforeseen circumstances such as illness, job loss, bad debt management, or other reasons such as the damage done to a family unit through divorce. Subprime lending is also called near-prime, nonprime, and second-chance lending. Those who get subprime loans are sometimes referred to as under-banked, meaning they lack bank accounts with substantial deposits.
All borrowers have a credit history that tells the story of their borrowing and repayment. Those borrowers with excellent or good credit ratings are those who have repaid loans promptly. Those borrowers with low or bad credit ratings have repaid slowly with delinquencies in prompt repayment or have defaulted on the loan. In contrast, lenders also have a lending record that tells the story of loans made, repaid, not repaid, and the money made and lost on the loans. All lenders, to stay in business, have to recover the principal on loans plus interest. They must incur only a few losses to make money for the creditor for the risks incurred and for increasing the capital available for lending.
C-paper is a subprime loan security that is expected to have a return that is above the prime rate of interest. Nonconforming loans in the United States are those that do not meet the standards of Freddie Mac and Fannie Mae. The reason for not meeting the standard can be any one of a long list of factors. In addition, bank loans to self-employed persons or on property that cannot be sold in the usual real estate markets may be subprime.
In the credit crisis of 2008, accusations against some subprime lenders claimed they engaged in predatory lending practices. The unscrupulous practices included playing on the ignorance of borrowers, lending to those who were unlikely to even make the interest payments, withholding information, and other fraudulent practices. In general, most predatory loans are subprime loans, but it is important to note that most subprime loans were not predatory.
Despite problems with predatory lending practices in the subprime market, most loans including those in the subprime category were bundled into securities issued by Real Estate Mortgage Investment Conduits (REMICs), which issued Residential Mortgage Backed Securities (RMBS) or other securities. These new types of securities were then sold to investors including pension funds, which historically invested in commercial mortgages or traditional real estate mortgages. The fees generated from these types of financial “products” were very profitable until the credit crisis bankrupted a number of large investment institutions involved in the business because the value of the RMBS seemed to vanish almost overnight.
Defenders of subprime lending claim that it gives credit to people who would not otherwise get loans.
In many cases these are people who will, unless harsh unforeseen circumstances arise, repay the loan even if occasionally delinquent. The higher interest rates and loan origination fees reflect the issues involved in making a subprime loan including the risk of default to the lender.
- Adam B. Ashcraft, Understanding the Securitization of Subprime Mortgage Credit (Now Publications, 2008);
- Richard Bitner, Confessions of a Subprime Lender: An Insider’s Tale of Greed, Fraud, and Ignorance (John Wiley & Sons, 2008);
- Frank J. Fabozzi and Robert Paul Molay, eds., Subprime Consumer Lending (Wiley, 2001);
- Melissa B. Jacoby, “Home Ownership Risk Beyond a Subprime Crisis: The Role of Delinquency Management,” Fordham Law Review (v.76/5, 2008);
- Douglas J. Lucas et al., Subprime Mortgage Credit Derivatives (Wiley, 2008);
- Robert J. Shiller, The Subprime Solution: How Today’s Global Financial Crisis Happened, and What to Do About It (Princeton University Press, 2008);
- Mark M. Zandi, Financial Shock: A 360° Look at the Subprime Mortgage Implosion, and How to Avoid the Next Financial Crisis (FT, 2009).
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