A sub-prime mortgage is a home loan provided to a borrower who would not otherwise qualify for a mortgage due to poor credit history, lack of income or liquidity, and/or excessive debt loads. Sub-prime lending became prevalent after Congress mandated greater mortgage availability to less qualified borrowers through the Community Reinvestment Act in the 1990s. The unintended consequence of this legislation was a much higher foreclosure rate in the U.S., culminating in the global financial crisis of 2008.
In mortgage industry parlance, sub-prime loans are known pejoratively as NINJA loans, meaning No Income, No Job, no Assets. Normal down payment requirements are waived for these borrowers, and many sub-prime loans have been structured in such a way that the borrower actually receives cash back at closing, effectively paying the borrower to buy the home. Of course, with no money down and cash back at closing, these sub-prime borrowers immediately find themselves in a negative equity position.
The lenders provide sub-prime loans to borrowers who couldn't otherwise qualify in order to earn higher rates of interest and charge higher fees. Since the higher fees are typically added to the loan amount, the borrower doesn't have to pay them up front.
The most common structure of a sub-prime mortgage is the adjustable rate mortgage. These mortgages amortize with an initial low “teaser” rate that keeps the monthly payments low for a pre-determined period of time. Once the initial period expires, the loan adjusts to a higher rate of interest, and is often indexed to an outside market force such as LIBOR (the London Inter-Bank Offered Rate). In a rising interest rate market, adjustable rate mortgage payments quickly become unaffordable to a large swath of sub-prime mortgage holders, resulting in default and foreclosure.
When thousands of properties go into foreclosure at the same time, the housing market collapses. This creates a vicious circle. As property values drop, more and more home owners become “upside-down” in their property, meaning that the current market value of the home is less than the amount owed on the home. In extreme cases of negative equity, even credit-worthy homeowners are tempted to walk away from the property, knowing it will take many years to recoup the loss of equity. This creates even more foreclosures and further exacerbates the problem.
Since the market crash of 2008, sub-prime lending has all but disappeared. With high profile bankruptcies such as Lehman Brothers and last-minute rescues like Bear Stearns and Merrill Lynch, lenders no longer have the appetite for risk. The credit markets have been slow to thaw and, thanks to proposed legislation, sub-prime lending may be a thing of the past.
From a financial planning standpoint, there really is no substitute for good credit and a substantial down payment when buying a home. Borrowers with poor credit or limited funds should work to rectify the problems in their financial situation before attempting an investment of real estate's magnitude.