The Effects of Subprime Mortgage Shouldn’t Be Forgotten
With a recovering economy and a newly vibrant housing market, we are beginning to see more data and articles referencing, and sometimes heralding, the revival of subprime mortgages. Mortgage industry stewards would do well by having longer memories. There is a reason prudent risk assessment and the “5 Cs of credit” warn against subprime mortgages.
What is a subprime mortgage?
A subprime mortgage is a type of loan granted to individuals with poor credit histories (often below 600) who would not be able to qualify for conventional mortgages due to their higher risk of defaulting on the loan. As we all know, the economic crisis in 2007 was a result of a collapsed housing bubble. Household debt was financed with high rates of subprime mortgages resulting in massive defaults, which led to the collapse of several major financial institutions. Rather than subprime mortgages originating at the historical 8 percent, these low quality loans constituted 20 percent of mortgage loans between 2004 and 2006. Lowered lending standards and the higher-risk mortgages sent our country’s economy spiraling.
What are the Five Cs of Credit?
The “Five Cs of Credit” is a method used by lenders to determine the credit worthiness of potential borrowers. The system weighs five characteristics of the borrower, attempting to gauge the chance of default.
- Character – Character refers to the borrower’s reputation and intent to comply with the agreed loan.
- Capacity – Often called the most critical C, “capacity to repay” is how the borrower intends to repay the loan. Lenders consider cash flow, the timing of the repayment and the probability of success.
- Capital – Capital includes savings, assets, investments, the down payment and ability to survive periods of loss of income.
- Collateral – When borrowing money, you may have to pledge something you own as collateral, representation of having “skin in the game.”
- Conditions – The lender evaluates how the borrower plans to use the borrowed money, along with environmental and economic conditions, to see if the loan suits its intended purpose.
How do the Five Cs of Credit Relate to Subprime Lending?
Subprime lending generally disregards the above proven standards for approving loans in return for higher rates and fees. The 2007-2008 financial crisis was built on lending from 2002-2006. The 2002 economic data and markets have a strong similarity to what we are starting to see today. The same players are beginning to emerge under new name plates with the same business model as 2002, hoping time has dulled the industry’s memory. They’re reintroducing their same sales pitch: “You can close more deals and make more money on the backs of those who could not meet conforming mortgage guidelines. You can do deals others turned down and win favor from referral sources.”
If you’re still unconvinced of the detriments of subprime lending, consider this:
- How many companies that specialized in subprime products survived the financial crisis of 2007-2008?
- How many of you reading this lost a job due to your company’s choice to originate subprime loans?
- How many of you had to reinvent yourself due to the company you trusted making this choice?
- How many of you built a successful career at a subprime company only to have your world turned upside down?
Quality, competent service and a proven track record void of default concentration in your referral sources projects is the only way to protect clients and your trusted partners.
Let’s Not Repeat This Pattern
At Southeast Mortgage, we’re passionate about the Mortgage Lending Industry. With this untimely revival in subprime mortgages on the horizon, we feel compelled to remind industry experts of the downfall of our industry in 2007-2008. Let’s not repeat history. We should all act as good stewards of our industry and forgo easy approvals or unsustainable products simply for profit. We should place our employees, shareholders, clients and the stability of our financial system at the forefront of our focus with the clear understanding that there is no shortcut to success. Success is achieved through the implementation of a slow methodical process that builds a solid foundation for growth.
We have a fantastic five years ahead of us. However, to sustain it we must be prudent and hold firm to sustainable strategies.