Subprime lenders have been strict about limiting bad credit offers for the past several years. The reason behind these restrictive measures is that subprime mortgage lending is what helped hurl the U.S. into a recession that shook the financial industry with dramatic worldwide implications in 2007.
Although subprime loans are still around, they are not approved as freely as they were in pre-recession times. Here is a thumbnail sketch of why subprime lenders have tightened the reigns on this risky sector of the lending market.
How Subprime Loans Work
People with good credit scores are typically able to borrow money at a relatively low interest rate from lending institutions. If people with credit issues want to borrow money, some institutions will still approve loans for them, but charge them higher interest rates and fees because they pose a greater credit risk. The worse someone’s credit rating is, the higher the chance they’ll be painted into a subprime loan corner.
Back in the ‘90s
In the decade preceding the mortgage industry’s downfall, government entities pressured lending institutions into originating a high volume of risky mortgage loans. The entitlement ideal that every American should be able to own a home is what generated much of the pressure, which resulted in many Americans with inadequate qualifications being approved to buy homes they couldn’t really afford.
Questionable Lending Practices
People who purchased homes before 1990 might remember jumping through an endless sea of financial hoops to prove their credit-worthiness to mortgage companies. With mounting pressure to make home ownership more obtainable, mortgage lenders did an about-face in the way they conducted business between the mid-1990s and the mid-2000s. They dropped their standards to the point where many home loans were automatically approved with little or no documentation and proof of eligibility.
In 1994, only 5% of mortgage loans were in the subprime category. In 1999 that number had grown to 13%, and by 2006, subprime mortgages accounted for 20% of total mortgages in the U.S. Also, in 2005 down payments on home purchases only averaged about 2%, and 43% of home buyers that year made no down payment at all.
The ARMs Race
By the time the mortgage crisis hit full stride, a high percentage of mortgages originating in the U.S. were low-interest adjustable rate mortgages (ARMs) with low monthly payments during the first two or three years. After the initial periods of these ARMs expired, steeper monthly payments kicked in, and many people who could not afford higher payments lost their homes through foreclosure. At one point, approximately 80% of subprime mortgages in the U.S. were ARMs.
Complicating matters, economic conditions were causing home values to plummet so the original $100,000 subprime mortgage loan was suddenly secured to a vacant property that was only worth $80,000.
Rising Foreclosures
As the subprime mortgage crisis shifted into overdrive, millions of families’ homes were foreclosed upon. A graph depicting foreclosures at Wikipedia illustrates that in the first quarter of 2007, there were 239,770 foreclosures. By the first quarter of 2010, that number had skyrocketed to 932,234 foreclosures.
This unbalanced financial situation pulled the high-risk plug on mortgage lenders and banks. Many small and medium-sized financial institutions were forced to close down as market conditions continued to deteriorate. Some of those that managed to stay afloat received billions of dollars in bailout money, causing the U.S. deficit pool to grow even deeper.
Subprime Loans Today
The current subprime loan market is one which is geared toward avoiding the mistakes of the past. Although this more costly form of financing is still available, decision makers are no longer willing to put a rubber approval stamp on anything that does not meet minimum pre-established qualifications.
It’s safe to conclude that the prime reason lenders are limiting subprime risky loans at the present time is to try to help the American market recover from its economic injuries.
Sources:
En.wikipedia.org
Finweb.com