These are loans provided at sub-prime rates against mortgage of property. Apart from the availability of sub-prime rates in-spite of not having eligible credit ratings, another incentive that drove these mortgages was that the US Tax Code had provisions to allow 100% tax deductibility of all interest payments and part of principal payments on housing loans. This would result in a tax break of 30% to 50%, on both real interest and inflation part of nominal interest rates which induced people to go for second and third mortgages, and use the proceeds to enhance consumer spending and car purchases. Sub-prime mortgage loans come with a higher rate of default than prime mortgage loans and are priced adjusted for the risk carried by the lender.
Sub-prime mortgages saw huge attraction in the early part of 21st Century and comprised about 21 percent of overall mortgage originations during the period 2004 to 2006 as against only 9 percent of overall originations during the period 1996 to 2004. Sub-prime mortgages became almost 20% of overall US home loan market in 2006 and amounted to approx $600 billion.
These mortgages also carry the following special features:
- Option to pay only interest for an initial period of about 5 to 10 years.
- “Pay option” loans, usually with adjustable rates, where borrowers can choose their form of monthly payment being either full payment or only interest or a minimum payment which could be lower than payment required to reduce the balance of the loan;
- “Hybrid” mortgages starting with fixed rates later converted to adjustable rates.
Hybrid class of mortgages have become popular since 1990s and commonly called the “2-28 loan”, 2 representing initial two years when interest rate is fixed and 28 representing remaining life of loan i.e. 28 years when loan gets reset to a variable adjustable rate typically a spread over a benchmark index like LIBOR. Other variations of hybrid mortgages are “3-27” and the “5-25”.