The first time that many of us had even heard of subprime mortgages, we were too busy watching the stock market collapse in 2008. Unfortunately, subprime mortgages continue to exist today and time will tell when/if they will cause major market problems again. Until then, it helps to know and understand the factors that got us there in the first place. Today, I want to discuss subprime mortgages and hopefully, this will help you to be more informed the next time you read the newspaper.

What is a "Subprime Mortgage"? 

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.

Are there different kinds of subprime mortgages?

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.

So what exactly are "ARMs" and how did they lead to the market meltdown in 2007-2007?

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. 

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.