The primary difference is that the borrower, due to problems with his or her credit report, down payment size, or income, cannot qualify at this time for a conventional mortgage. Lenders who were willing to take the risk of having the borrower not pay back the loan invented mortgages that, while appealing to the ignored potential borrower, also provided additional protection to the lender.
Beyond just having a high interest rate on a mortgage, subprime lenders brought out three different types of subprime mortgage loans.
1. Interest only mortgages. These allowed the homeowner to pay only the interest on the loan for a period of time (usually five to ten years). That made the mortgage payments smaller, but since the payments were only going against the interest, the borrower was not buying any equity or ownership in the house. When that period of time elapsed, the borrower then needed to refinance the house. The amount that needed to be refinanced was the amount left to pay for the loan (interest) plus the price paid for the house (principal) minus any owner’s equity. Without any equity in the house the subprime borrower needed to obtain a loan for the original selling price plus any interest payments left. In a buyer’s market, where the value of housing is dropping, this type of loan is almost impossible, especially for a person without a good credit rating.
2. Pick a payment loan. This mortgage allowed the borrower to select the type of payment he or she was going to make. They could make a full payment (including interest and principle), pay interest only, or a set minimum payment. While this allowed the borrower to obtain some equity in the home, it was far too easy for the borrower to just pay the bare minimum. Again, as many of these loans expired the borrowers needed to obtain refinancing.
3. Convertible loan. This is a hybrid creation that would begin as a fixed rate mortgage then after a period of time would quickly convert to a variable rate mortgage. The rate was typically some margin (or percentage) over a federal index number. The problem with a variable rate is that monthly payments could increase rapidly, causing the borrower to be unable to anticipate how much to set aside for housing at any month.
What all of these mortgages had in common was protection for the lender. The protection was in the form of high interest rates, severe prepayment penalties, or an easy foreclosure where the lender took ownership of the home and resold it for a profit.