subprime definition
December 12, 2007 6:29 AM Subscribe
Dear bankers and other financial experts: What is the basic definition of a subprime loan? I've seen "at least 2 points above prime," "at least 3 points above prime," "between 2 and 5 points above prime." Is there a single definition or does each bank define subprime differently?
Related question: Is there a standard dictionary or encyclopedia of financial terms that you can recommend for these sorts of questions? Thank you.
Related question: Is there a standard dictionary or encyclopedia of financial terms that you can recommend for these sorts of questions? Thank you.
BTW, I was also confused about the use "prime" in these two contexts when the expression "subprime loan" came out in the media. At first , I thought it meant a loan at a rate below the prime rate (which didn't make much sense).
posted by bluefrog at 6:50 AM on December 12, 2007
posted by bluefrog at 6:50 AM on December 12, 2007
I think the OP wasn't asking what points and prime were, but rather what number of points above prime counted as subprime.
I don't believe that the number of points above prime is what qualifies a loan as subprime, rather that's an effect. A subprime loan is what banks give to people who are considered too risky for a regular "prime" loan (at least in theory, you could have been eligible for a prime load but tricked into getting a subprime loan). If you have a terrible credit rating, you'll only be able to get a subprime loan, but the actual interest rate will vary based on your credit rating, current interest rates, and the particular lender.
If you are asking in the context of the US government's plan to freeze interest rates, from what I can tell, qualifying for the freeze doesn't care what exact percentage points you are away from prime. Rather, it's targeting people who have an ARM that they can afford the teaser rate on, but will not be able to afford the reset rate.
As for a dictionary of financial terms, try Investopedia. It has much less detail than Wiki, but covers more terms (it's more like a dictionary than an encyclopedia).
posted by justkevin at 7:15 AM on December 12, 2007
I don't believe that the number of points above prime is what qualifies a loan as subprime, rather that's an effect. A subprime loan is what banks give to people who are considered too risky for a regular "prime" loan (at least in theory, you could have been eligible for a prime load but tricked into getting a subprime loan). If you have a terrible credit rating, you'll only be able to get a subprime loan, but the actual interest rate will vary based on your credit rating, current interest rates, and the particular lender.
If you are asking in the context of the US government's plan to freeze interest rates, from what I can tell, qualifying for the freeze doesn't care what exact percentage points you are away from prime. Rather, it's targeting people who have an ARM that they can afford the teaser rate on, but will not be able to afford the reset rate.
As for a dictionary of financial terms, try Investopedia. It has much less detail than Wiki, but covers more terms (it's more like a dictionary than an encyclopedia).
posted by justkevin at 7:15 AM on December 12, 2007
bluefrog is correct. "Prime" is being used in two different ways. Sub-prime loans means that the borrower is of low quality. "2-5 points above prime" refers to an interest rate which is more expensive than the prime rate, a rate each bank posts as the one it charges its best customers, usually a fixed increment above fed funds.
posted by shothotbot at 7:28 AM on December 12, 2007
posted by shothotbot at 7:28 AM on December 12, 2007
Response by poster: Yes, I am asking if there's a standard points above prime threshold that makes a loan "subprime."
Thanks for the clarification on subprime referring to the borrower not the rate. I hadn't thought of it in quite that way and it makes more sense now.
Also, thanks for the link to Investopedia. If anyone has an academic source they use that would be helpful, too. I can usually get access to pay resources so don't worry if it requires a subscription.
posted by otio at 7:38 AM on December 12, 2007
Thanks for the clarification on subprime referring to the borrower not the rate. I hadn't thought of it in quite that way and it makes more sense now.
Also, thanks for the link to Investopedia. If anyone has an academic source they use that would be helpful, too. I can usually get access to pay resources so don't worry if it requires a subscription.
posted by otio at 7:38 AM on December 12, 2007
As far as a reference works go, a free and authoritative, though dated, resource is this guide to the money markets published by the Federal Reserve Bank of Richmond. Here (pdf) is a guide to ARMs from the fed.
Your mandatory non-interest bearing deposits at work!
posted by shothotbot at 7:42 AM on December 12, 2007
Your mandatory non-interest bearing deposits at work!
posted by shothotbot at 7:42 AM on December 12, 2007
I don't know if it's different in the US, but in Canada we use "points" usually referring to "basis points".
One basis point is 1/100th of 1%. So when I am telling clients their mortgage rate is 25 basis points above prime, that means that their rate is 6.25% (where the prime rate is currently 6% here in Canada).
posted by smitt at 8:44 AM on December 12, 2007
One basis point is 1/100th of 1%. So when I am telling clients their mortgage rate is 25 basis points above prime, that means that their rate is 6.25% (where the prime rate is currently 6% here in Canada).
posted by smitt at 8:44 AM on December 12, 2007
I've read through some of the comments, and I think a few of you have got this wrong.
The prime rate is the bank's prime lending rate. I'm not sure what it is in the US, but Canada's is 6%.
Sub-prime loans are loans which often had low introductory rates (prime - XX basis points).
So say your monthly payment is $500.
Say $400 of that goes to principal and $100 to interest.
The prime rate changes, goes up, your monthly payment stays the same. It's still $500.
But now you're only paying $350 to principal, and $150 is going to interest. You're paying off less of your mortgage principal.
In bad situations of rate change, your $500 payment is going ENTIRELY to interest, and may not even be coverring the entire interest charge. Your payments may go up.
Then five years pass, and your mortgage is up for renewal. The bank tells you that at current interest rates, your low $500 monthly payment is now renegotiated. Suddenly your easy to manage $500/mo payment has jumped to $1250/mo.
You can no longer afford your house, or the mortgage. So you move out, let the bank foreclose, and the bank takes a hit.
This is a very very simplistic view and I'm ignoring many factors. Also I'm seeing this from the outside, because we do mortgages differently in Canada, so I could be highly inacurate on a few things, so forgive me.
posted by smitt at 9:03 AM on December 12, 2007
The prime rate is the bank's prime lending rate. I'm not sure what it is in the US, but Canada's is 6%.
Sub-prime loans are loans which often had low introductory rates (prime - XX basis points).
So say your monthly payment is $500.
Say $400 of that goes to principal and $100 to interest.
The prime rate changes, goes up, your monthly payment stays the same. It's still $500.
But now you're only paying $350 to principal, and $150 is going to interest. You're paying off less of your mortgage principal.
In bad situations of rate change, your $500 payment is going ENTIRELY to interest, and may not even be coverring the entire interest charge. Your payments may go up.
Then five years pass, and your mortgage is up for renewal. The bank tells you that at current interest rates, your low $500 monthly payment is now renegotiated. Suddenly your easy to manage $500/mo payment has jumped to $1250/mo.
You can no longer afford your house, or the mortgage. So you move out, let the bank foreclose, and the bank takes a hit.
This is a very very simplistic view and I'm ignoring many factors. Also I'm seeing this from the outside, because we do mortgages differently in Canada, so I could be highly inacurate on a few things, so forgive me.
posted by smitt at 9:03 AM on December 12, 2007
Best answer: The term "sub-prime" refers to a loan which is higher-priced because of the credit-worthiness of the borrower relative to the loan. The borrower's credit, or the loan itself, is less than ideal, or sub-prime. The "prime" in "sub-prime" does not refer to the prime interest rate (or teaser rates as smitt implies).
That said, HMDA data (the main source for US mortgage data; many but not all mortgage lenders are required under federal law to submit this data) does define "higher cost loans" as follows (this is from a footnote on page three in this Federal Reserve analysis of 2006 HMDA data (pdf link)
For loans with spreads above designated thresholds, revised Regulation C requires the reporting of the spread between the APR on a loan and the rate on Treasury securities of comparable maturity. The thresholds for reporting differ by lien status: 3 percentage points for first liens and 5 percentage points for junior, or subordinate, liens.
For another take on what subprime "means", see this Calculated Risk post:
What is Subprime?
posted by yarrow at 9:22 AM on December 12, 2007
That said, HMDA data (the main source for US mortgage data; many but not all mortgage lenders are required under federal law to submit this data) does define "higher cost loans" as follows (this is from a footnote on page three in this Federal Reserve analysis of 2006 HMDA data (pdf link)
For loans with spreads above designated thresholds, revised Regulation C requires the reporting of the spread between the APR on a loan and the rate on Treasury securities of comparable maturity. The thresholds for reporting differ by lien status: 3 percentage points for first liens and 5 percentage points for junior, or subordinate, liens.
For another take on what subprime "means", see this Calculated Risk post:
What is Subprime?
posted by yarrow at 9:22 AM on December 12, 2007
Subprime seems to be a term of art.
This is from a Q&A in Friday's Wall Street Journal (about the mortgage plan agreement announced by the Bush administration):
How do I know if I have a subprime mortgage?
"The agreement doesn't provide a definition of subprime ARMS because it isn't always clear. Typically, subprime ARMS carry a fixed interest rate for the first two or three years, then adjust annually. Borrowers who aren't sure whether or not they have a subprime ARM can ask the company that collects their loan payments."
Later the article says: "The program is designed to help borrowers who aren't good candidates for refinancing because of a poor credit score, have little or no equity in their homes or a history of late payments. To qualify for the fast-track program, borrowers must have a credit score of less than 660 and it can't have improved by more than 10% since the mortgage was originated."
posted by croutonsupafreak at 11:05 AM on December 12, 2007
This is from a Q&A in Friday's Wall Street Journal (about the mortgage plan agreement announced by the Bush administration):
How do I know if I have a subprime mortgage?
"The agreement doesn't provide a definition of subprime ARMS because it isn't always clear. Typically, subprime ARMS carry a fixed interest rate for the first two or three years, then adjust annually. Borrowers who aren't sure whether or not they have a subprime ARM can ask the company that collects their loan payments."
Later the article says: "The program is designed to help borrowers who aren't good candidates for refinancing because of a poor credit score, have little or no equity in their homes or a history of late payments. To qualify for the fast-track program, borrowers must have a credit score of less than 660 and it can't have improved by more than 10% since the mortgage was originated."
posted by croutonsupafreak at 11:05 AM on December 12, 2007
Response by poster: Lots of good info here. Thanks again!
posted by otio at 12:03 PM on December 12, 2007
posted by otio at 12:03 PM on December 12, 2007
It's subjective, of course. We went through this 20 years ago with "junk bonds". They're junk until they're not junk, although you can't quite separate them from being junk at that time because actually being junk is the allure of the business. And eventually the bubble burst and they turned out to have been junk after all. It wasn't a trick!
It's also something that changes over time. I just read today a quote to the effect that the earlier "vintages" (yes, that's the term of art) of mortgages are still performing quite well; it's only the most recent few years that are problematic and default-heavy. That's because the business actually expanded faster than the pool of actual subprime borrowers, so the various lenders had to dig deeper into the mud, so to speak. They were overly concerned with losing business to each other, so what was subprime became riskier and riskier with every passing week.
posted by dhartung at 10:04 PM on December 12, 2007
It's also something that changes over time. I just read today a quote to the effect that the earlier "vintages" (yes, that's the term of art) of mortgages are still performing quite well; it's only the most recent few years that are problematic and default-heavy. That's because the business actually expanded faster than the pool of actual subprime borrowers, so the various lenders had to dig deeper into the mud, so to speak. They were overly concerned with losing business to each other, so what was subprime became riskier and riskier with every passing week.
posted by dhartung at 10:04 PM on December 12, 2007
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posted by bluefrog at 6:47 AM on December 12, 2007