The complete guide to subprime for dummies (Part 1)

November 21, 2007

You notice how when you type the word “subprime” on MS Word, a squiggly red line shows up below it indicating a misspelled word? That’s because its a recent word. But it’s been gaining popularity in the news pretty quickly.

As is appropriate. Since this issue concerns all of us. Which is why I am going to try my best to give a comprehensive explanation of this crisis in simple terms for everyone to understand. I am going to do so in parts, since although the complete picture must be understood, their are many aspects to the story.

Hopefully this explanation in some way influences avoiding the trend to occur again.

What is subprime?

Properly referred to as “B-paper,” “near-prime,” or “second chance lending,” subprime in laymen terms refers to “giving out big loans to those with poor credit.”

e.g.

Johnny wants to purchases a home worth $350,000. He must put down $80,000. And take out a loan for $270,000.

At his $32,000 a year job, a below average credit score of 600, and nothing to show for in his savings account, no banks in their right mind will give out a loan to Johnny, or others like him. Normally, the story should stop here since Johnny can’t even afford the down payment ($80,000). But the subprime story has only begun.

Since Johnny’s loan officer, Mindy, stands to make a little percentage from this transaction (getting Johnny the loan), she ‘modifies’ his information to get Johnny approved. She also gets Johnny a second loan for the money down.

The credit score can’t be altered. But in the loan application papers, Johnny is shown to make a yearly salary of $45,000, he has $10,000 in his savings account, and has no other major debts or monthly obligations.

Bank 1 gives Johnny a fixed mortgage rate for the money down ($80,000) at 9.75% . His monthly payments for the small loan is $700.

Bank 2 gives Johnny a 2/1 Adjustable Rate Mortgage (ARM) for the $270,000 at 7.25% — with the understanding that this rate will rise in two years. His monthly payment for the big loan (at the moment) is $1500.

Click here to view a New York Times interactive graphic showing where such subprime mortgages were most prevalent.

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