What are sub-prime loans?

In the 1960s and 70s, many lending institutions would use a process called redlining to deny loans. Redlining is using boundaries to determine who would qualify for a loan. Typically redlining prevented minority groups or people living in less desirable neighborhoods from owning a home. When this process became widely known, steps were taken to halt the practice. The mortgage industry was deregulated and a system was set in place to encourage those who previously could not buy a home to become homeowners.

This process was not without its faults, however. As the housing market heated up, lenders looked for ways to loan to those who technically should not be considered for loans. A sub-prime loan is the term used for loans that are risky than a traditional loan. A buyer may have a legitimate reason for needing a sub-prime loan, but for many, the sub-prime loan was a way to purchase a home that they really could not afford. Along with sub-prime loans came loosened restrictions on underwriting loans, and many no-down payment- no document loans were written. Buyers could qualify for a home loan with a credit score below 600.

A person in need of a sub-prime loan is considered a non-conforming buyer. Some reasons that a buyer may fit these qualifications are if they have a poor credit history, they cannot document their income, or they are buying an expensive home. Because federal loan amounts, backed by Freddie Mac or Fannie Mae, are limited to $417,000, any amount greater than this is considered a jumbo loan, and required special financing. Sub-prime loans traditionally have a higher delinquency rate.

What has happened to the real estate market?

Although it seems that everyone is losing their home, the situation is not that dire. Roughly 14% of sub-prime loans go delinquent. While this number is higher than traditional loans, it is still has an 86% repayment rate. Because sub-prime mortgages are aimed at those that would not qualify for a traditional loan, it stands to reason that the delinquency rate would be higher.

For sub-prime loans to work properly, the housing market must be relatively stable, and homes must continue to increase in value. When this does not happen, delinquencies increase. With an adjustable rate mortgage, which these sub-prime loans typically are, the monthly payment can increase dramatically. In the past, when these rates increased, the homeowner could refinance the home. However, with a stagnate housing market, the home may not appraise for the amount needed. When this happens, the owner cannot refinance, and they are stuck with the higher monthly mortgage payment.

It is interesting to note that 35% of the homes that are foreclosed in the sub-prime market are investment properties. These are typically second properties, purchased by the owner who hopes to fix the home up and "flip" it, or sell it quickly, ideally before the first payment is due. When the housing market quieted down, and these homes sat on the market, the owners were locked into not only their primary residence, but making mortgage payments on the investment property as well.

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