TheStreet

In a famous quote, insanity was defined as doing the same thing over and over again while expecting different results. It's a well-known quote, unless you work at a bank, apparently.

Over the past few years, banks and other borrowers have been eagerly handing out "non-prime" mortgages to high-risk borrowers. Don't be fooled by the low-effort attempt at rebranding. These are subprime loans, and anyone who has read about the Great Recession - or worse, experienced it - knows the role they played in it.

If you don't know the role these played in the recession of the late 2000s, or even what they are, it's important to familiarize yourself with subprime loans - what they are, how they work, why people borrow them and what they've done to economies in the past. What are subprime loans?

What Are Subprime Loans?

A subprime loan is a loan offered to prospective borrowers who are unable to qualify for a standard prime rate loan. These borrowers are seen as high-risk for reasons like a poor credit score or low income.

Because lenders are concerned about the borrower's ability to pay the loan, there is a much higher than average interest rate on them, and it is expected that the borrower will pay monthly. This leads to higher monthly payments as the lender hopes to get as much payment back as soon as possible, unsure that the borrower will be able to pay the entire loan back over time.

The monthly payments often take up a sizable amount of the borrower's paycheck. It's not uncommon for borrowers of a subprime loan to default on it, unable to keep up with the payments.

Problems with credit score and income are among the most common things that can turn someone into a high-risk borrower. Others include:

  • A relatively recent foreclosure or bankruptcy declaration
  • Inability to provide proof of consistent income sufficient to pay off loan
  • Debt-to-income ratio of over 50%

Types of Subprime Loans

Several different types of loans can be subprime loans. When one thinks of subprime loans, the first thing their mind always leaps to, with good cause, is mortgages. But car loans, student debt and credit card debt, among others, can be subprime loans if you are seen as a high-risk borrower.

How the borrower pays off their loan can also vary. Some lenders offer different ways of paying off the loan, whether to help make it more affordable for the borrower or simply to make it more enticing for them to agree to the loan.

Some of the more notable types of subprime loans that exist are:

  • Interest-Only Loan. True to the name, this subprime loan offers borrowers the ability to pay only the interest of the subprime loan for the beginning of its duration. This means more affordable monthly payments at the start of the loan, which can allow for the potential of a faster repayment. But eventually the payments increase as the interest takes a backseat to the loan itself. The difference in price can be steep. And if this interest-only loan is a mortgage, your ability to pay will be dependent on the new price of the house. If the market is bad, you may not be able to sell your house in time to avoid the worst of the loan.
  • Adjustable-Rate Loan. Here, the interest rate on the loan stays flat for the beginning of its duration, changing to a floating rate later on. As an example, say you have a 20-year loan. If it's adjustable-rate, perhaps the first two years of the loan have a flat interest before changing over the rest of the time, be it gradually or suddenly. Like with interest-only loans, the idea behind this loan is so borrowers can better pay it off earlier in the hopes that down the line a steadier income or improved credit score will make paying off the steeper interest rate easier.
  • Fixed-Rate Loan. With a fixed-rate subprime loan, the interest rate doesn't change, staying consistent the entire duration of the loan. What tends to happen, though, is that the duration of the loan lasts longer than your average loan. The usual is about 30 years, but a fixed-rate loan can be as long as 40-50 years. A borrower may be inclined to choose a fixed-rate loan due to the lower monthly payment than other subprime loans, but the interest rates on them tend to be higher.
  • Dignity Loan. In a dignity subprime loan, the borrower must put down a down payment equivalent to about 10% of the loan and agree to a higher interest rate for the initial portion of the loan. If monthly payments are made on time for this period (five years is a common time frame), the interest rate decreases down to the prime rate. In addition, the amount already paid on interest will go toward reducing the balance of that loan.

Pros and Cons of Subprime Loans

The pros of getting a subprime loan can often be more of an "in theory" deal. In theory, they allow people struggling financially to still get a house, car, credit card or education despite qualifications that would normally get them turned down from financial institutions. In theory, the right loan, despite the high interest rates that come with subprime loans, can be more affordable early on and give you time to improve your finances before the payments increase.

Sometimes, this can work out. If the first few years of an interest-only or adjustable-rate subprime loan are affordable enough that you consistently make your payments, that can be a boost for your credit score.

But often it does not work out. One of the biggest drawbacks of a subprime loan is that they tend to be a massive chunk of the borrower's monthly income. That's not a ton of wiggle room. If someone on a subprime loan suffers an unexpected financial issue like a medical emergency, that borrower now has to figure out how to prioritize their finances. They may not choose the loan as their current priority in that instance.

Subprime loans can easily be seen as predatory on the part of a lender. Borrowers that resort to subprime loans do so because they are seen as more likely to default on a loan. But people still require shelter and transportation, and the desperation to have that is something that has been preyed upon in the past. Often, loans made like this do not work out.

How Did Subprime Loans Affect the Great Recession?

When a lot of those subprime loans don't work out, there can be - and have been - repercussions that spread to the entire economy.

You only have to look a decade into the past for proof of this. One of, if not the biggest causes of the Great Recession is literally referred to as the subprime mortgage crisis. The 2000s were a time when, at a casual glance, the housing market couldn't be better. Interest rates were low, and more and more Americans were buying homes. It seemed great.

In reality, financial lenders were handing out subprime loans on a monumental level, and as a result a many of these home buyers were high-risk. Lenders also sold these subprime mortgages in packages as mortgage-backed securities. Because so many subprime mortgages were being given out, many of these MBSs that were being invested in were actually, for the most part, filled with risky loans.

Still, the housing market hummed along as people slowly began to realize there might be a bubble. The Federal Reserve started worrying about inflation and the rising prices of homes, and raised the interest rate more than a dozen times in just a few years. What started as a booming housing market suddenly became a disaster. Those on subprime mortgages couldn't afford their monthly payments with the new interest rates, and couldn't afford new homes as prices continued to rise. Houses were foreclosed upon, and swaths of suburban streets because desolate and abandoned.

The lenders that were happily giving out all of these subprime loans suddenly had no money now that all these loans were being defaulted on, and layoffs became increasingly common. What made this so disastrous was that, swept up in the housing bubble, major financial institutions decided to get into the world of subprime mortgages and mortgage-backed securities. In particular, Lehman Brothers began issuing MBSs and acquiring subprime lenders to be part of the company.

The subprime mortgage crisis was so bad that it was able to take down as large an institution as Lehman Brothers. No attempt to stop the bleeding worked for the company, and after closing down the subprime lenders they had purchased just a few years prior, they filed for bankruptcy in September of 2008.

The rapid decline of Lehman Brothers threw a wrench into Wall Street and the American economy, and as confidence in the system eroded, the U.S. (and the entire world as a result) fell into a recession.

Subprime loans were seen as poison after the fallout of the recession and as the economy slowly tried to recover. But they continue to exist, and worryingly may be on the rise. With student loan debt crushing millennial's finances and wrecking their debt-to-income ratio, CNBC reported that subprime loans, now being referred to as nonprime loans, were making a comeback. This includes financial institutions as large as Fannie Mae lowering their standards for approving loans.