Definition of Subprime Lending
With all of the talk about subprime
lending and its detrimental effect on the economy, many people
are wondering exactly what is subprime lending and am I at risk?
What is subprime lending? The definition of subprime lending is
the loaning of money to people who are at a higher credit risk than
normal. If your FICO score is under 680 you are in the subprime
category. This means that if you want to borrow money, you will
most likely have to go to a institution that specializes in subprime
lending and you will pay a higher interest rate.
How does subprime lending work? Subprime lending works like this.
You have a low credit score (FICO
score) and a not so great credit report. This puts you at subprime,
which means that you are at a higher risk for defaulting on your
loan. Due to the fact lenders see you as a high risk borrower, many
will not lend to you. Those that will are going to charge you a
higher interest rate. How high depends on how low your scores are
and what your credit report looks like. The subprime lender will
loan you money usually over a longer period of time and at a higher
rate. This is how it all works.
What is the subprime
lending problem? The problem with subprime lending started and
still continues to be that people are borrowing more money than
they can afford. Up until very recently you could borrow up to 125%
of a homes value. Other loans that were offered were interest only
loans, 80/20 loans, negative amortization loans and many others.
The problem with all of these loans is that after closing on a
home the new owner is left in a
negative equity situation. Equity is the difference between
what you owe on a property and what the property is worth. Most
people getting into these loans figured the housing market would
continue to rise and they would be able to refinance in 3-5 years.
That gamble did not pay off as they bought at the top of the housing
market.
In many areas real estate has taken a severe downturn and many
of these individuals cannot refinance. To compound the problem many
of them have ARM or adjustable rate mortgages. They qualified at
very low "teaser" rates and this rate has continually
adjusted up. Most have some form of a cap on them so they cannot
increase forever, however many readjust every 2 years or so and
they are tied to long-term rates, so all of the recent rate cuts
which effect the short term rates have no effect on these ARMs.
It is possible that many have seen their mortgage payments almost
double as rates readjust and they went from paying 5% to 8 or 9%.
Combine that with rising gas and oil prices, increased food costs,
and you have a real problem. When these individuals can no longer
make their mortgage payments, and get 3 months in arrears, the bank
starts foreclosure proceedings.
This further compounds the problem as foreclosure sales lower the
real estate values in a neighborhood. This is the definition of
the subprime lending problem.
So what can we do about it? If your situation falls into the definition
of subprime lending, do not panic. If you are making your payments
on time and your mortgage is current, then you do not have anything
to worry about. If you are one of the people who are in trouble,
talk to your lender. They may be able to offer some relief.
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