What went wrong?
The problem can be traced back to 2001 when a housing bubble began to form in USA and several other countries. This bubble was caused by:
Historically low interest rates.
Poor lending standards.
A mania for purchasing houses.
The bubble kept on burgeoning till 2005. There was rapid increase in the value of real property. Since the rates of interest were quite low and there was a boom in the real estate sector, demand for home loans kept on increasing.
Concept of sub-prime rates of interest
Lenders use credit scores to determine who qualifies for a loan, at what interest rate and at what credit limits. Credit scores of borrowers are usually obtained by the banks and other lenders from the credit bureaus or credit reference agencies and these represent the credit worthiness of the borrowers. The individuals with a credit score of more than 620 often get loans at Prime or conventional rates. Individuals who have experienced severe financial troubles often have doubtful creditworthiness and thus are labelled as higher risk and therefore cannot obtain conventional financing. These people do not qualify to borrow at prime rates and therefore borrow at sub-prime rates.
Sub prime loans or mortgages are risky for both creditors and debtors because of the combination of high interest rates, bad credit histroy and murky financial situations often associated with sub prime applicants. From a servicing standpoint, these loans have higher collection defaults and also lenders have to incur high costs in their recovery. Lenders charge higher interest rates to offset these anticipated higher costs.
In USA since housing market was booming, the lenders took the risk and lent to people with poor credit ratings but at s ...