The term “subprime” refers to loans offered to individuals at a higher rate as compare to prime rate. Because of their poor credit history and financial situation of the borrower, they are unable to qualify for a prime rate. Subprime loans are usually used to finance mortgages. So what is subprime mortgage?
A subprime mortgage is granted to borrowers with low income or bad credit which is not sufficient enough to get a conventional mortgage. It offers to consumers a way to purchase a home meanwhile builds up their credit history. Subprime mortgages carry a higher interest rates than similar mortgages available in the prime mortgage market. Subprime mortgages is risky for both the lenders and the borrowers because of the combination of high interest rates and applicants’ poor earnings.
Many subprime mortgage programs have been designed in the market. One of them will be interest only loan. Interest only loans made a lot of subprime mortgage possible. Suddenly, anyone can own a house or purchase a bigger house with little or no downpayment. As compared to conventional mortgage, the monthly payment is much cheaper. That is because homeowners were only paying the interest, and never paying down principal. This loan could be dangerous. The interest rate remains fixed for a period of time after that, they convert to conventional loan which definitely make the monthly payment much higher.
When the housing market falls, homeowners usually could not sustain the increased installment neither could they afford to sell the home. If they failed to meet the financial obligation, ownership of property will be passed to the mortgagee. This puts homes on the market for a forced sale, which drags prices down and makes it more difficult for other subprime borrowers to refinance their mortgages into loans with better terms.
Many lenders have made big losses for making these types of loans. Due to this reason, several financial companies have closed down their business. Reduction of financial companies in the markets causes less people able to get a mortgage to buy a house. This will lowered the demand for homes, therefore reduced in construction jobs. With that, it leads to unemployment. With a decline in real estate sale, prices of the real estate without fail will also falls. This contributes to the values of everyone’s home lowered. The amount of home equity loans is also affected thus resulting consumers to spend lesser. The only good thing for this is, it lessen the chances of inflation. Manufacturing jobs that produce big-ticket items will also have to stop or limit production. As the orders deline, manufacturers got no choice but to hire less workers or even lay off existing workers to cut cost. With more people getting jobless, the spending of the people eventually drops. This will also affect the retail sector which will cause retrenchment and increase the unemployment rate. It is a chain of events that eventually will cause the economy to weaken.
In conclusion, subprime loans have its advantage and disadvantage. It creates more opportunities for homeownership. However, the downside is that suprime loans are too expensive. They have high interest rate and hidden costs. Not only that, some subprime loans often accompanied by prepayment and other penalties. When the interest rate increases and the housing market value falls, the entire industry will be affected. Borrowers unable to pay, financial companies closed down, people declared bankrupt. All in all, this leads to many undesired consequences to the economy. Despite the fact that subprime loans have more disadvantages than advantages, the loans itself are neither good nor bad because it is just an economical tool.
