What is Subprime
Subprime is a classification of borrowers with a tarnished or limited credit history. Lenders will use a credit scoring system to determine which loans a borrower may qualify for. Subprime loans carry more credit risk, and as such, will carry higher interest rates as well. Approximately 25% of mortgage originations are classified as subprime. The term subprime gets its name from the prime rate, which is the rate at which people and businesses with excellent credit history are allowed to borrow money.
BREAKING DOWN Subprime
Occasionally some borrowers might be classified as subprime despite having a good credit history. The reason for this is because the borrowers have elected to not provide verification of income or assets in the loan application process.
Subprime Mortgages and the Global Financial Crisis
Many of the subprime mortgages made in the years before the global financial crisis were made with an adjustable interest rate that allowed borrowers to start the first several years of their mortgage with an extremely low payment. After the first three or five years, the interest rate adjusted upward and made the monthly mortgage payments extremely expensive for the borrowers. Many borrowers could not afford to pay them after this adjustment took place.
Before the global financial crisis, subprime loans such as mortgages were packaged together into large pools of loans and sold to investors. It was assumed that there was safety in numbers and because so many thousands of loans were pooled together, it was thought that even if some of them defaulted, the mortgage pools would remain sound investments because of the false assumption that the majority of the borrowers would still pay their mortgage payments.
The thousands of loans made to people who could no longer afford to make the payments after their interest rates adjusted upward ended up defaulting, the pooled mortgage investments went under, and all of this helped to fuel the global financial crisis.