Sub prime lending is something that many people point to as the biggest cause of the recent mortgage crisis. What is sub prime lending? How does it differ from other kinds of lending? What part did sub prime lending play in the mortgage crisis? Here is a brief explanation of how it all relates.
When a bank, or other lending institution, is in the process of deciding if it is financially beneficial for them to offer a person a loan, many things are considered. Potential loans are divided into two categories: “Prime” and “Sub Prime”.
Prime lending means the bank is lending money to a person who has a good credit rating. This person has never defaulted on a loan in the past. Based on this great credit history, the bank feels that this person will pay back the loan. Prime lending is considered to be low risk for the bank. As a result, the bank may offer this kind of loan with a lower interest rate than would be offered for a sub prime loan.
Sub prime lending, on the other hand, is the opposite of prime lending. If a person has a bad credit rating, or already has defaulted on a loan, the person will not qualify for prime leading. The bank is going to see this person as a risk. If he or she didn’t pay off their previous loan, what assurance does the bank have that he or she will pay off this new loan? Sub prime lending means the bank has offered a loan with a very high interest rate to a person who has a poor credit history, a bad credit score, or insufficient documentation. The high interest rate is there to compensate the bank for it’s potential losses if the person defaults on this new loan. People turned down by banks could seek sub prime loans from other lenders.
The result was that a lot of people who would not have normally been able to qualify for a mortgage loan were able to get one. More people could obtain “the American Dream” of home ownership, and more money was circulating, which was good for the economy. When housing prices dropped, many people defaulted on their mortgages. It can be argued that if these risky sub prime loans were never given out, the economy wouldn’t have experienced as negative an impact as it did.