A subprime mortgage is a type of loan granted to individuals with poor credit histories (often below 600), who, as a result of their deficient credit ratings, would not be able to qualify for conventional mortgages. Because subprime borrowers present a higher risk for lenders, subprime mortgages charge interest rates above the prime lending rate.

There are several different kinds of subprime mortgage structures available. The most common is the adjustable rate mortgage (ARM), which initially charges a fixed interest rate, and then convert to a floating rate based on an index such as LIBOR, plus a margin. The better known types of ARMs include 3/27 and 2/28 ARMs.

ARMs are somewhat misleading to subprime borrowers in that the borrowers initially pay a lower interest rate. When their mortgages reset to the higher, variable rate, mortgage payments increase significantly. This is one of the factors that lead to the sharp increase in the number of subprime mortgage foreclosures in August of 2006, and the subprime mortgage meltdown that ensued. (To learn more, read The Fuel That Fed The Subprime Meltdown.)

Many lenders were more liberal in granting these loans from 2004 to 2006 as a result of lower interest rates and high capital liquidity. Lenders sought additional profits through these higher risk loans, and they charged interest rates above prime in order to compensate for the additional risk they assumed. Consequently, once the rate of subprime mortgage foreclosures skyrocketed, many lenders experienced extreme financial difficulties, and even bankruptcy.

For more information, read Subprime Lending: Helping Hand Or Underhanded?

  1. How much risk is associated with subprime mortgages?

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  2. Are subprime mortgages still available for homeowners?

    Buying homes became increasingly difficult after the housing bubble burst. Since then, subprime mortgages have been making ... Read Answer >>
  3. What role did securitization play in the U.S. subprime mortgage crisis?

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  4. What are the different types of subprime mortgages?

    Clarify your understanding of subprime mortgages. Learn about the different types, how they work and when they might be beneficial. Read Answer >>
  5. What is the difference between a 2/28 and a 3/27 ARM?

    An adjustable rate mortgage (ARM) is a type of mortgage that has a fixed interest rate for a certain time period at the beginning ... Read Answer >>
  6. What is a liquidity squeeze?

    A liquidity squeeze occurs when a financial event sparks concerns among financial institutions (such as banks) regarding ... Read Answer >>
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