Capital markets operate on the basic premise of risk versus reward. Investors taking a risk on stocks suppose a higher rate of return than do investors in risk-free Treasury bills, Guaranteed Investment Certificates, etc. which are backed by the full trust and credit of the issuing country or institution. The same goes for loans. Supposedly less creditworthy subprime borrowers represent a riskier investment, so lenders will charge them a higher interest rate than they would charge a prime borrower for the same loan. To avoid the first hit of higher mortgage payments, most subprime borrowers take out adjustable-rate mortgages (ARMs) that give them a lower first interest rate. But with potential annual adjustments of 2% or more per year, these loans can end up charging much more. So a $500,000 loan at a 4% interest rate for 30 years equates to a payment of about $2,400 a month. But the same loan at 10% for 27 years equates to a payment of $4,220. A 6-percentage-point increase in the rate caused slightly more than a 75% increase in the payment. This is even more obvious when the lifetime cost of the loan is measured. The total cost of the above loan at 4% is $864,000, while the higher rate of 10% would incur a lifetime cost of $1,367,280.
On the other hand, interest rates on ARMs can also go down in the US, some interest rates are tied to federal government-controlled interest rates, so when the Fed cuts rates, ARM rates go down, too. Most subprime ARM loans are attached to LIBOR. ARM interest rates typically adjust once a year or per quarter, and the rate is based a calculation specified in the loan documents. Also, most ARMs limit the amount of change in a rate. The cycle of increased fees due to default-prone borrowers experiencing trouble is a vicious cycle. Though some subprime borrowers may be able to repair their credit rating over time, some default again and may even turn to bankruptcy. While usurious interest rates improve the profits of subprime lenders, they can also lead to frequent cases of putting consumers in positions they cannot recover from without resorting to bankruptcy.
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