Unless you’ve been living in seclusion for the last twenty years, then you’ve probably heard of subprime mortgages at some point.
But what is subprime lending and who are these loans meant for? How do these types of loans work? Moreover, what is the relationship between subprime loans and the financial crisis that wiped out trillions of dollars worth of wealth. These are just some of the questions that might come to mind for those who are unfamiliar with subprime lending.
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What Are Subprime Loans?
Subprime loans are specifically designed for those who may have a difficult time making their monthly payments. For example, people who have been unemployed for a while, divorced or who spent a large portion of their savings on medical emergencies might fall under this category.
These borrowers may also have a very limited credit history, which would cause any lender to be wary. Personal assets such as stock holdings, Roth IRAs, mutual funds or a house are not usually present. Such borrowers may also have excessive debt and a history of making late payments. Accordingly, subprime borrowers typically have credit scores less than 640.
For all of these reasons, it’s very much a gamble to issue a subprime loan. After all, these types of loans are specifically catered to people who face a higher risk of default than most borrowers. To offset the risky nature of these loans, lenders usually tack on higher interest rates and less favorable terms for the borrower.
How Do Subprime Loans Work?
Getting a subprime mortgage is more or less just like getting any other type of mortgage. In this case, a borrower with a low credit score applies for a loan and then gets approved by a lender. In turn, the lender sells that loan to an investment bank and uses the money that gets collected to issue other loans.
Investment banks then proceed to take all of these subprime mortgages that they receive and package them into what are called mortgage-backed-securities. Investors are obviously hoping to turn a profit on these loans when they buy them, but as we’re about to see that doesn’t always work out.
What Role Did Subprime Lending Play in the Financial Crisis?
When subprime borrowers begin to fall behind on their payments, this makes them too risky for most investors so they are no longer able to be sold. So, the investment banks have now lost out and lenders cut off funding for new subprime loans. The investment banks prior to the crash were effectively left with toxic assets that caused many of them to go under. Here’s another way to think about this whole scenario.
Imagine buying a room full of green apples in the hopes that you’ll be able to sell them at a profit. You invest 90% of your savings in these green apples thinking you’ll make lots of money from selling them. Now imagine a world where people just stopped caring about green apples because a new study came out saying they may be dangerous. This study shows they may be linked to “Hulkingson’s disease,” a rare type of skin cancer which causes the victims skin to turn green.
The public gets scared and red apples become all the rage. And try as hard as you’d like, no one seems to want to buy your green apples. Your assets simply don’t have the value they once did and you’re almost completely out of money in this scenario. This is akin to the precarious situation many investors found themselves in prior to the crash.
