What is Subprime Mortgages?
In the early beginning of the Mortgage system, the way it was done was; the banks or lenders will loan the money to the prospective borrower to buy his/her house.
The borrower then paid back the loan plus the interest to the lender or the bank. The interest paid being pocketed by the lender or the bank. This is perfectly fine.
If for some reasons, like your health, your employment changes, your interest rate changes or other circumstance changes, and you are not able or cannot afford to pay your mortgage, the lender or bank will foreclose your mortgage. By foreclosing your mortgage, the lender will be able to resell your house and try to recover what is owed to them. When the lender resells your house after foreclosure and was not able to sell for as much as the money stills owing, the lender or bank losses money.
When borrowers asked to make a loan the banks or lenders will make an assessment of the prospective borrower base on his or her ability to repay the loan. The banks make classification and categorise borrowers from “prime borrowers” which are least risky. Beneath them, there are various categories that the banks would categorise them. Banks try to classify each type of borrower in order to determine how much interest rate will be given to a specific type of borrower and the risk involved.
As investors try to get their hands on anything that likely makes money for them, thus subprime borrowers come into play. People try to hang on to their houses no matter what, and base on this premise, the prospects of investing on mortgages looks very lucrative and safe for investors. And soon the banks being that greedy fat giant, start giving subprime mortgages even to those people they know they will not be able to pay their mortgages eventually. People given mortgage loan at subprime are charge higher interest rates and thus your lender will make more money.
Fluctuating interest rates are also a big factor in the bank strategy on how to make more money from borrowers. For instance, if you are currently charge with 4.5 percent and then a week or two later will be 9 percent, the banks would like to make money of those spread. Thus the change in interest rate for the borrower’s loan then increase on their monthly payment and also an increase in risk.
For most subprime mortgage, they offer low interest rate initially but after a couple of years it will go up and become unpredictable. Almost everyone knows about this. This strategy will give more profits later on.
With so many different kinds of mortgages, the lenders and or banks realise that they will make a whole lot of money selling mortgages. But it is harder to sell the high risk mortgages. The idea is if you take 10 different medium risk ones and bundle them and the risk is less. If one of the 10 fails, you still have the other nine. Because they are independent the risk of one failing does not increase the risk of the others failing. So what next is take those higher risk mortgage bonds and bundle them up into Meta bonds.
Now when you buy a mate bond, instead of the money going directly into the bunch of mortgages, your money is used to buy a bunch of different higher risk mortgage bonds, and then those bonds are used to make loans. You get higher interest rate because you are investing into riskier loans, but because you supposedly spread the risk, they are safe as the original low risk bonds. And they are insured.
The risk is low because these loans are backed by the home value. So even if the borrower defaults and foreclose on their Mortgage you can still have your investment back.
With these types of mechanism of mortgages, the investors are very happy to have more of these high interest low risk bond packages. Then banks began bundling a lot more of these types and made killing. It is almost risk free in the sense that they are insured.
But this is where it goes in circular motion. You bundle them together according to a complicated scheme called tranching to make them look like they are really and truly safe. And you take insurance, so that if something goes wrong, it is all insured. Investors love this stuff.
With the current subprime mortgage crisis, the insurer is bound to lose. Well not quite literally. The banks know very well that they need to ensure that the insurance companies will not collapse. The reason is this; the insurance company is guaranteeing the value of the bank mortgage loans, using the money it borrowed from the banks, which the bank had to borrow to because it got these bundles of leans insured by the insurance company. In other words, the banks are insuring themselves, using the loans to pay for the losses on the loans. This is perfectly a way of running in circles.
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Other Relevant Topics You Need Know : Mortgage Refinancing Loan in Britain, Consolidate Debt Loans, School Loans, College loans, School Consolidation Loan, Debt Consolidation, Mortgage Refinancing.
