A sub prime loan is a loan that is offered at a rate above prime to individuals who do not qualify for prime rate loans. Sub prime loans are risky for both lenders and borrowers and tend to have a rate that is 0.1% to 0.6% higher than the prime rate.
Sub prime markets are led by lenders, offering loans to people of questionable or lower credit ratings. It includes the business of sub prime mortgages, sub prime auto loans and sub prime credit cards. Typically, sub prime lenders charge a higher interest rate because the risk of default is much higher. Changing interest rates are not likely to affect sub prime lending because sub prime borrowers usually cannot refinance their debt until their credit rating improves.
The health of the sub prime market is very dependent on the strength of the economy. When people are employed and earn a fair income, they are more likely to repay their debts. Sub prime lending disappears very fast in a weakening economy, because lenders will avoid taking excess credit risks.
It is estimated that the subprime mortgage world comprises 15% of all mortgages, or approximately $1.5 trillion. Currently about 10% or $150 billion is thought to be in arrears. Of that, half is in default and will likely be seized in foreclosure, which according to the Center for Responsible Lending will lead to 2.2 million borrowers losing their homes along with $164 billion of wealth. Bank of America reports similar conclusions estimating that the current foreclosure level of approximately 400,000 homes could rise to over 2 million before the end of 2009.
By early 2008 nearly $2 trillion in subprime-backed securities purchased over the past seven years – not only by banks but also by insurance companies and pension funds – still need to be marked down to reflect the impact of increased defaults on the securities’ underlying value.
It is projected that one out of five (19%) subprime mortgages originated during the past two years will end in foreclosure. This rate is nearly double the projected rate of subprime loans made in 2002, and it exceeds the worst foreclosure experience in the history of the modern mortgage market, which occurred during the oil disaster of the 80s.1