What is a subprime mortgage?
If you were reading the news in 2007 (or anytime since) there’s a good chance you’ve heard of subprime mortgages. Subprime mortgages are a type of mortgage product that played a large role in the Global Financial Crisis (GFC). While the story of subprime mortgages is mostly based in the United States, Canada was seriously affected by the GFC and does have a subprime mortgage market.
But what is a subprime mortgage, and what did they have to do with the subprime mortgage crisis in 2007? Perhaps most importantly, are subprime mortgages a problem in Canada today?
What is a subprime mortgage?
A subprime mortgage is any mortgage issued to an individual who is at a higher risk of not being able to pay it back. The term “subprime” refers to the borrower having less than ideal financial circumstances, generally in the form of a low credit rating. To make up for the extra risk to the mortgage provider, subprime mortgages come with higher interest rates and less favourable terms than regular mortgages.
The exact definition of subprime mortgages vary, but mortgages issued to people with credit scores of less than 600 to 640 are generally considered subprime. Because subprime mortgages are only given to people who cannot be approved for a regular mortgage, they are sometimes called “second chance” or “last resort” loans.
Which lenders offer subprime mortgages?
In Canada, subprime mortgages are offered by “B Lenders”. B Lenders are mortgage providers that specialize in providing mortgages to people with lower credit scores or who, for other reasons, aren’t able to be approved for a regular mortgage from an “A Lender”. A Lenders include the big banks (eg TD, CIBC, etc) as well as mid-sized banks and credit unions.
Compared to regular mortgages, mortgages from B Lenders come with higher interest rates, less favourable terms, and fewer features. This is because people who take out subprime mortgages are more likely to default. The additional cost of a subprime mortgage compensates B Lenders for that additional risk.
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The subprime mortgage crisis
A major cause of the global financial crisis (GFC) of 2007 and 2008 was related to subprime mortgages in the United States – specifically, the subprime mortgage crisis that directly preceded the GFC. But what part did subprime mortgages play?
The short version is that more subprime mortgages were issued across the United States in the years leading up to the crisis – from 8% of mortgages in 2003 to 20% in 2006. This caused a housing bubble across the country, with house prices being increased artificially, due to additional demand from subprime borrowers. Many of these mortgages were issued with mortgage rates that increased over time.
Many of these mortgages were bundled into financial products called “Mortgage-Backed Securities” (sometimes called collateralized debt obligations, or CDOs). These securities were (mistakenly) given high ratings by rating agencies, and they offered investors higher returns than government bonds. The trading of these securities further lowered lending standards, making it easier for subprime borrowers to take out mortgages.
In 2006, the housing bubble burst, with home prices across the US falling significantly. This made it more difficult for borrowers to refinance their loans. When many subprime mortgages reached the time where their interest rates rose, default rates soared. However, these subprime mortgages were no longer secured by a home that was worth the value of the outstanding loan.
As a result, the mortgage-backed securities that had become so popular lost most of their value. This began a vicious cycle of economic downturns that culminated in the global financial crisis.
This is a gross oversimplification of both the subprime mortgage crisis and the global financial crisis, but it is hopefully enough to demonstrate that the risk of subprime mortgage is borne by both individuals and the economy as a whole.
Should you get a subprime mortgage?
If you have a low credit rating but would like to buy a home, you might wonder whether you should consider getting a subprime mortgage for yourself. The best advice is to avoid taking out a subprime mortgage at all costs. There are many ways to get a mortgage with bad credit, and you should explore the alternatives before signing on for a subprime mortgage.
That said, not all subprime mortgages are the same, and many offer reasonable terms. You also may have the option to refinance your mortgage at a later date, which could give you access to the regular mortgage market if your circumstances have improved.
To get advice on your options, the best thing you can do is speak to a mortgage broker. Consultations with mortgage brokers are free and will arm you with expert information and advice about the options available to you.
Subprime lending in Canada today
Thankfully, subprime lending never took hold in Canada the way it did in the United States. While there were and continue to be subprime mortgages and B Lenders operating in Canada, they are highly regulated and have not been so widespread as to cause major problems (yet!). Of course, that didn’t stop the global financial crisis affecting Canada in 2007.
Today, governments and regulators are diligent when it comes to keeping subprime lending under control, while investors are warier of mortgage-backed securities.
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Subprime mortgages and the coronavirus pandemic
There is some concern that the economic downturn caused by the coronavirus pandemic could see subprime mortgages become a problem again. The theory goes that, as people continue to be without work, subprime mortgages could default in record numbers, starting a similar chain-reaction to what we saw in 2006.
While this is not impossible, the market for mortgage-backed securities is far smaller, especially in the US, than it was in 2007, which reduces the risk of this happening. There is some concern about the risk posed by “Collateralized Loan Obligations” which are similar to mortgage-backed securities, but they bundle subprime business loans rather than mortgages. Whether these pose a significant risk to global banking during the ongoing pandemic is yet to be seen.
The bottom line
For both the financially literate individual and the prospective homeowner, the best thing you can do to avoid the risks of subprime mortgages is to understand them as best you can. Knowledge is power in this case, as it lets you understand the risks and avoid a situation where a subprime mortgage is your only choice.