Subprime lending is normally determined by the creditworthiness of borrowers. A subprime loan is, by design, a loan made to someone who does not meet the criteria for a more favorable rate. Subprime borrowers tend to have low credit scores due to histories of late payments, or bankruptcies. They are considered at higher risk of default on loans; therefore subprime lenders typically offer less favorable terms than their traditional counterparts. These terms may include higher interest rates and fees, or some sort of an up-front charge.
Proponents of subprime lending defend the role it plays in extending credit to consumers who would otherwise not have access to credit; and a fairly high percentage of subprime borrowers find a way to make their scheduled payments and not go into default. Critics have condemned subprime lenders for predatory practices, which have been known to include targeting borrowers who did not have the means to meet the terms of their loans over the long term.
The real estate boom experienced in most parts of the United States between 2002 and 2006 emboldened lenders to take more risks and to relax their credit standards. During the boom, many subprime lenders have made loans to borrowers who did not earn enough money to make the monthly payments. Some reports suggest that subprime lenders did not even bother to verify borrowers’ incomes and/or assets by issuing so-called “stated loans” and “No Income, No Asset” loans which do not necessitate proof of income and/or assets. Wall Street may have encouraged this behavior as well, by bundling subprime loans into securities that were sold to pension funds and other institutional investors seeking higher returns.
Some of the largest subprime mortgage lenders started experiencing considerable problems in their mortgage loan portfolios last year. This year, a number of them have filed for voluntary bankruptcy protection, ceased originating mortgage loans and/or stopped conducting business altogether. Because many of the subprime mortgages had artificially low initial interest rates, it took a while for the problems associated with subprime loans to surface. Trouble in the subprime markets might have been avoided had home prices continued to climb, because as homes values appreciate, even borrowers/homeowners who are not paying the principal loan amount build equity in their residences as property values appreciate. That in turn would have made it easier for subprime borrowers to refinance into yet another loan with a lower interest rate (a variation on the ponzi scheme).
Since home prices have weakened in most parts of the country, lenders have become more vigilant, and as a result refinancing is no longer an option for many subprime borrowers who are facing dramatically higher payments. The interest rates on an estimated $265 billion in subprime mortgages are scheduled to increase sometime in 2007. Some of those borrowers could be facing annual interest rates as high as 12 percent if they are not able to refinance. Many of the companies that offered subprime loans are facing criminal investigations into their accounting and business practices.
The subprime lending practices of the last several years could affect all homeowners even if they are not subprime borrowers. In a worst case scenario, if the wave of anticipated defaults on subprime mortgages continues, it could lead to tighter lending standards thus reducing the number of people able to buy real estate. This could combine to drive down home values which would further reduce a homeowner’s wealth.