Prime Concern

Usually, we explain an investment term here. This time around, we decided to explain a "lending" one - sub-prime. Sub-prime is now very much part of the vocabulary of stock market investors and observers across the globe. They might have not known what it meant a few years ago, but they certainly do so now. And, it has managed to scare the living daylights out of them. The rest of them who do not know what it means are, nevertheless, quite certain that it is the cause of the current global markets crisis.

Sub-prime loans are given to borrowers who do not qualify for regular loans. The reasons are either low earnings, bad credit history or both. Individuals in the US have credit scores ranging from 300 to 900. Creditors take different factors into consideration like payment history, delinquencies, bankruptcies, length of credit history, debt-to-income ratio, amount of credit, and type of credit when building a credit score. Though each lender has its own definition of what constitutes a sub-prime borrower, it generally is an individual with a credit score of less than 620.

Since the risk to the lender is higher, sub-prime loans always have a higher interest rate than a regular loan. They are mostly adjustable rate loans with a low rate of interest for the first two years. After that period, the rate can move up significantly. Such loans also tend to attract a prepayment penalty or a balloon payment, or both.

A prepayment penalty is a fee that the borrower has to pay should he pay off the loan before its complete tenure. So, if the tenure of the loan is 10 years and the borrower wants to clear the loan in the sixth year, a prepayment penalty is levied. A balloon payment will require the borrower to pay off the entire outstanding amount in a lump sum after a certain period. If he fails to do so, he will have to refinance the loan or sell the house.

At best, this is just a gamble. The borrower has got a loan despite evidence that he may not be able to make the payments. He would have put down very little money, if none at all. Should he have to sell the house, he assumes that the price of the home would rise during that time frame, enabling him to make a profit on the sale.

Though these loans are much tougher than those paid by the credit-worthy individuals, the size of this market is huge. According to an article that appeared in Fortune earlier this year, in 2006, 13.5 per cent of mortgages that originated in the US were sub-prime compared to 2.6 per cent in 2000. Overall, the sub-prime market was pegged at $600 billion in 2006, 20 per cent of the $3 trillion mortgage market.