I bought my first home back in February of 2008. I was young and dumb enough that I had no idea what was going on in the housing market. Thankfully, I had a good credit score (even if my credit history was a little short) and was purchasing with a VA loan. So many others were not as lucky.
Many borrowers have credit scores that are too low for lenders to see them as a safe risk. If a borrower doesn’t pay their debts, lenders almost always have to take some kind of loss – not a good business practice if you care about making a profit.
The homeowner who uses a subprime mortgage loan risks losing their home and taking a huge hit to their credit score – something that could cost them much more money in the long run and limit many of their credit options for years.
Lenders try to mitigate their increased risk by charging higher interest rates for those deemed to be at a higher risk of default. These types of loans are considered subprime loans – they are given to borrowers who do not qualify for the best rates because their income is not high enough, they have too much debt, or they have low credit scores due to lack of credit or credit problems.
Lenders would often sell these subprime mortgages to investment banks – for a fee of course, who would then package the debts with securities and sell them to investors (Petroff, n.d.).
From 2001 to 2005, subprime mortgage lending increased from $120 billion to $625 billion (Gilbert, 2011). In 2006, more than two-thirds of subprime mortgage loans issued were adjustable rate mortgages, with a lower initial rate that generally increased later – often significantly so (Gilbert, 2011).
By 2007, the housing bubble was about to burst. Subprime home mortgage loans accounted for fewer than 20 percent of mortgages but made up over half of the mortgages that became delinquent to the point of foreclosure (Gilbert, 2011). The numbers of foreclosures were also climbing, with a 53 percent increase in foreclosure initiations in 2007 over 2006, many of these being adjustable rate mortgages (Gilbert, 2011).
There are indications that people involved in subprime lending were aware of some of the problems, but chose to continue targeting less qualified lenders in order to make short-term profits before selling the debts to investors (Gilbert, 2011). As subprime lending practices became more common, the percentage of mortgages becoming delinquent also rose significantly (Demyanyk & Van Hemert, 2011).
When the subprime crisis peaked, businesses involved in mortgages struggled to survive, resulting in stock market decreases, tens of thousands of people losing their jobs, billions of dollars lost, and millions of Americans losing their homes (Gilbert, 2011).
Demyanyk, Y., & Van Hemert, O. (2011). Understanding the subprime mortgage crisis. Review of Financial Studies, 24(6), 1848-1880. http://dx.doi.org/10.1093/rfs/hhp033
Gilbert, J. (2011). Moral duties in business and their societal impacts: The case of the subprime lending mess. Business & Society Review, 116(1), 87-107. http://dx.doi.org/10.1111/j.1467-8594.2011.00378.x
Petroff, E. (n.d.). Who is to blame for the subprime crisis? Retrieved March 22, 2017, from http://www.investopedia.com/articles/07/subprime-blame.asp