Get our drift yet? If you are a borrower, this is a place you would rather not be. Classically defined, well maybe not classically but as we define them, a sub prime loan has at least one feature that prevents most lenders from seeking this type of loan. Usually, this feature is outside the normal underwriting guidelines for conforming and jumbo loans. The most common feature here is a borrower’s poor credit rating. However, the unconventional aspect of the property itself could be the culprit as could a borrower’s unusual employment situation or even extremely volatile income. Whatever the reason, one thing is always clear, a sub prime loan will carry an interest rate premium over a more conventional type loan.
Years ago, these loans were originated by lenders that would expect to keep them for the duration of their term. Because of the unconventional nature of these loans, it was difficult for a lender to find a buyer for this type loan. Hence, the expectation that the original lender would hold the loan for its duration. Since the demand for this type of loan was not great, the in place mechanism for funding these loans, supply of funds was sufficient to satisfy the demand for funds. However, for a variety of reasons, the demand for these loans increased to the point that there were no longer lenders able to continue to fund these loans and hold them for their duration. What developed was a secondary market for these loans. A mechanism for the lenders of these loans to sell them to investors thereby replenishing their funds so that they could continue to make these sub prime loans.
This secondary market is very much like the secondary market that developed for jumbo loans. Many of the same Wall Street firms that are a vital part of the jumbo secondary market are likewise a very integral part of the sub prime market…they package these loans into mortgage backed securities and sell these securities to the investing public. Recognizing the risk differentials between a conventional jumbo loan and an unconventional sub prime loan the investing public expects a return for a sub prime loan to be commensurate with the increased risk, that is, the investing public expects a higher return.
In order to maintain the higher returns necessary for the investing public, sub prime loans have interest rates, margins and caps which are typically much, much higher than those on more conventional conforming and jumbo loans. Moreover, sub prime loans almost always carry a prepayment penalty typically as long as two to three years.