You may probably have heard about the Global Financial Crisis of 2008. But what led to this crisis was the Subprime Mortgage Crisis that took place in the United States in early 2006. Fortunately, Canada was not affected as much as the United States by the crisis, but it wasn’t spared from the brunt. Are you also wondering what is a subprime mortgage, how the crisis took place, and can it happen again? Let us find out in this article.
The housing demand in the U.S began to increase post-2000, the reasons were lower interest rate and liberalized laws. That led people to buy a house even if they could not afford it. But the question is how can they buy a house if they cannot afford it? The answer is a subprime mortgage.
When a person buys a house in Canada, he or she has to pay between 5 to 20 percent as a down payment depending on the purchase value of the house. But that was the north case in early 2000 in the United States. A lot of people got a subprime mortgage which is a mortgage given to people not having a good credit score. If we talk about Canadian terms, we can say that a person having a credit score of around 600 to 640 is considered to have poor credit.
The person cannot get a normal mortgage loan and thus has to go for a subprime mortgage. It is offered by ‘B lenders’. A normal term mortgage is offered by ‘A lender’, which mostly includes big banks or recognized financial or credit institutes. What happens next is the role that investment banks played and lure the financial market to its downfall.
What Happened in the Subprime Mortgage Crisis?
The mortgage-based loans were buckled up and called Mortgage-Backed Securities (MBS). They were secured as Credit Default Swap (CDS). CDS works in a way that if the party, in this case, the homeowner fails to pay the mortgage on the house, the party taking CDS, here the insurance company would be paid back by the institute selling CDS.
Well, it is a lot more complicated than it seems because these CDS were further combined into Collateralized Debt Obligation (CDOs). It is a mixture of various kinds of risky assets and sold by investment banks across the globe. The subprime mortgage loans were having poor credit but yet investment banks sold them rigorously. So when homeowners failed to pay their mortgages, insurance companies started claiming on investment banks.
Clearly, investment banks were not ready for this unfortunate turn of events as they never thought people would default and house prices would fall. That led to financial troubles and eventually paved the way for the Subprime Mortgage Crisis, followed by the Global Financial Crisis. The interesting thing here is that the CDOs that were used as financial instruments for trading were given higher ratings by the big three rating agencies even when they were very poor in terms of credit.
Who Gives Subprime Mortgages in Canada?
Individuals in Canada can avail subprime mortgages by ‘B landers’. Though people cannot get favorable terms here as they have lower credit. It is very crucial that if you are going for a subprime mortgage, you have to be aware of the interest rate, terms of the loan, and other features that may concern you in the future. It is also advisable that you consult a mortgage broker before making any decision.
Should You Opt for a Subprime Loan?
Apart from getting a subprime mortgage, there are numerous ways in which you can fund your dream house. You can follow the below points for the same.
Work on Your Credit Score and Improve It Over Time
If you have a higher credit score you can easily get a mortgage loan with a lower interest rate. In order to improve your score,
- You should pay your bills on time.
- You should use only 70 percent of your credit limit and have some space for the rest whether you are using a credit card or a line of credit.
- Also, avoid applying for too many credit cards because it would affect your credit score.
- Pay off your debts on time and in full.
Secure a Large Amount for Down Payment
The below is the data on how much down payment you will have to pay in order to secure a house in Canada.
|House Rate||Minimum Down Payment|
|Less than $500,000||5 percent of the house purchase rate|
|Between $500,000 to $999,999||5% of the first $500,000 of the house purchase rate|
10% for the portion of the house purchase rate above $500,000
|More than $1 million||20% of the purchase price|
If you choose 5 to 20 percent as a downpayment, you might have to pay a higher interest rate on your mortgage loan. You will also have to buy a CMHC Mortgage Default Insurance as that is a crucial requirement in cases where the down payment amount is below 20 percent of the house value. It would eventually increase your cost.
So, when you choose to pay more than 20 percent as a down payment, it shows that you are financially stable and can secure a loan with a lower interest rate.
Apply for a Mortgage with a Co-signer or Co-borrower
This is a little tricky because you have to convince a third person to become your guarantor and sign on your behalf to take the responsibility for paying the monthly mortgage payments if you fail to do so. In Canada, the mortgage lender would mostly require the co-signer to also be a part-owner of the house. Apart from a co-signer, you can also get a joint mortgage if more than two or three people are living in a home. You can jointly buy a house and get a mortgage increasing the credibility to pay back the debt.
Can Coronavirus Repeat the Financial Crisis?
History doesn’t repeat itself but it does rhyme. Also due to the ongoing pandemic, people have lost their jobs and the financial situation is tricky which might lead them to opt for buying a house on a subprime mortgage.
We have to understand that while a mortgage works as a tool for us to buy a house, it is a tool for investment banks to trade and earn money. Compared to the year 2007, at present, the market for Mortgage-Backed Securities is quite limited. But another similar instrument called Collateralized Loan Obligations (CLOs) is trying to create its own trajectory.
Time will tell if the same event would repeat, would it be the same again, and if yes, then what would be the impact of it! In Canada, the government has firm regulations to control subprime mortgages and protect investors as well as homebuyers.
The Bottom Line
While in the time of such a crisis, you cannot do much but what you can do is protect yourself. Remember prevention is better than cure. Try to reduce your debts and prioritize saving money and investments.
Also, educate yourself about such financial instruments and how they can impact your life. Give preference to sorting your personal finance and understand the risk involved in opting for any kind of credit including credit card, car loan, home loan, etc. Increase your knowledge of finance, implement disciplined habits, and the rest will take care of itself. All the best!