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There has been a lot of talk in the news lately about sub-prime mortgages, the credit crisis, and a possible recession caused by these issues.  For those who don't work in the real estate, banking, or mortgage industries, are wondering just what is meant by all these different issues and how exactly they're related, we can help.  There is a very simple explanation as to what sub-prime mortgages are, how they led to the current credit crisis, and how this situation is affecting the U.S. economy overall.

The term "sub-prime mortgages" applies to those mortgages that were approved for those whom many banks would have turned down.  This may include those with a spotty credit history or who earned less than most banks would think is the minimum salary requirement to be eligible for a mortgage.  Some years back, many smaller mortgage companies sprang up with more relaxed requirements for those applying for mortgages, and the term sub-prime mortgages began to be used for these applicants.

Normally mortgages rates are based on the prime rate which is determined by the federal government.   A percentage point or two is added to the interest rate for standard mortgages for the lending companies’ profit margin.  This mortgage interest rate could increase or decrease over the life of the loan based on the prime interest rate fluctuation (variable mortgages) or the mortgage interest rate could be locked in as a specific rate (fixed mortgages).

Sub-prime interest rate mortgages were given with interest rates below the prime rate with an automatic increase to the standard rate usually within two years.  People could now qualify for the new lower rate that could not have qualified for the standard rate.  Home owners believed they would be able to afford the new rates within two years or they could simply refinance to a new mortgage hoping the prime interest rate would continue to drop.

Well, the prime interest rate went up and now home owners were faced with mortgages that increased two, three or even four hundred dollars a month with no way to qualify for a new mortgage.  Could you pay four hundred dollars more for your home mortgage and not feel the bite?

One thing to remember when trying to understand how these sub-prime mortgages affect the economy overall is that rarely does a mortgage company or bank itself actually carry mortgages as debt themselves.  Typically what they do is turn around and sell those mortgage notes to larger banks and investment firms.  These investment firms and banks then use those mortgages as collateral or as part of their overall financial portfolio in order to sell bonds against their value.  There are only a few major banking institutions that actually carry mortgages, including sub-prime mortgages, which mean that when people start to default on their home loans this does not affect just a small fly-by-night mortgage company.  Those larger banks and institutions now have a large part of their financial portfolio that is beginning to fold. 

When these larger banks and lenders felt the pinch of mortgages going into default, they then needed to compensate somehow and make sure that other areas of their financial portfolio were left intact.  This meant that they came up with stricter rules for who could get credit from them; when economic times are good, banks typically have less stringent credit requirements, but when times are bad, they clamp down on those requirements.

This scenario is referred to as the credit crisis or credit crunch.  These home mortgages that have been defaulted on have made it more difficult for the average consumer to get credit.  When the average consumer can no longer get credit as easily as before, he or she is less likely to spend money on non-necessities, whether on everyday items such as clothing and household goods, or for big ticket items such as electronics, appliances, and travel.  These home mortgages that are being defaulted on are now affecting the retail and service sector of the economy, as they are not doing the business that they once did.  All of these factors are what may very well lead to a recession.

And of course there are many other factors that have affected the sub-prime home mortgages crisis and that this crisis affects other industries well.  For example, home building has slowed to nearly a halt in many areas, idling literally thousands in the construction industry.  Because so many homes have been foreclosed on, this drives down home prices in these areas as other home sellers cannot compete with empty homes that banks need to sell quickly.  This means that many have actually lost equity in their homes as they are forced to lower their prices drastically if they want to sell at all.

David Cowley has created numerous articles on real estate investing. He has also created a Web Site dedicated to real estate investing. Visit Real Estate Investing

Article Source: ArticlesBase.com - The Problems Caused by Sub-prime Mortgages