Subprime Lending

SUBPRIME LENDING

Q: What is 'Prime Lending Rate'? Q: What is 'Prime Lending'?

Prime Lending Rate: PRIME LENDING RATE is the interest rate that commercial banks charge on loans to their most favorable, credit-worthy customers. ● Default risk is one of the primary determiners of the interest rate that a bank will charge a borrower. Since loans to creditworthy customers carry a low risk of default, the prime rate is typically the lowest rate of interest on bank loans at a given place and time. ● The prime lending rate is also used as a reference rate, and is used to calculate the total rate of interest on loans. The bank's most creditworthy customers borrow at rates below the prime rate. The total interest rate on such loans is calculated as follows: Total Interest = Prime Rate + SPREAD; where: Prime Rate is Variable Spread is fixed ● Commonly used reference rates include: 1. Wall Street Journal Prime Rate 2. London Interbank Offered Rate (LIBOR) ●

Thus, 'Prime Lending' and 'Sub-prime Lending' can be defined as follows: PRIME LENDING : Prime Lending constitutes the loans offered to creditworthy customers with a low risk of default. These loans are offered at prime lending rates, which are comparatively lower. ●

SUB-PRIME LENDING : Sub-prime lending constitutes the loans offered to customers with low credit-worthiness, and carry a high risk of default. These loans are offered

at high interest rates, to offset the high risk of default.

Prime Lending v/s Sub-prime Lending:

Parameter Prime Lending Lending Creditworthiness of High Borrower Low Risk of DefaultInterest Rate Low

Sub-prime Low High High Low

Subprime Lending – An Overview

WHAT IS SUB-PRIME LENDING AND WHO DOES IT SERV E? Subprime lenders offer mortgages to people who represent a higher level of risk than borrowers who meet standard prime underwriting guidelines. Subprime borrowers do not qualify for market interest rates owing to various risk factors, such as, income level, credit history, employment status, size of the downpayment made, etc. In general, there are three different types of products offered to subprime borrowers: ● Home purchase and refinance mortgages targeted to borrowers with poor credit histories. Refinance mortgages account for a larger share of these loans: over 80 percent of loans originated to borrowers are for refinance purposes. In a majority of cases, borrowers refinance mortgages for an amount greater than the unpaid principal on the original mortgage, thereby taking “cash out” of the transaction; ● High loan-to-value (LTV) mortgages, originated to borrowers with relatively good credit, but with LTV ratios that sometimes exceed 150 percent. These loans are refinance mortgages. ●

Subprime borrowers are more likely to have low incomes and/or a weak credit history. Subprime borrowers in general also tend to be less financially knowledgeable and sophisticated and less comfortable dealing with banks. Underwriting standards in the subprime mortgage market vary from lender to lender and are not guided by secondary market standards as in the prime mortgage market. As a result, it is difficult for borrowers to determine

whether or not a loan offered by a subprime lender is the best loan for which they qualify given their individual risk profiles.

A BRIEF HISTORY OF SUBPRIME LENDIN G ● Subprime lending grew rapidly in the 1990s. Between 1993 and 1998, subprime lending increased 760 percent for home purchases and 890 percent for refinance mortgages; during the same period the prime market grew 38 percent and almost three percent, respectively. ● The subprime market’s growth can be attributed to a number of interrelated factors. These include: Federal Legislation Preempting State Limits on Mortgage Terms The National Economy and Accompanied Increases in Property Values Increased Levels of Consumer Debt Technological Developments Changes in Financial Markets Search for Increased Profits Excess Capacity Among Lenders ●

Some of these factors are discussed below.