Sub prime-loans are loans granted against mortgages to people whose credit history is less than perfect to what is warranted by the financial institution. Hence these people cannot access the conventional mortgage loans with this deficiency and therefore finds the sub-prime loans a blessing to finance their needs. It is to be noted that since the risk of default is more sub-prime loans carry higher interest rates than the prime lending rate. Although there is no fixed convention on the exact amount of spread to be charged over and above the prime rate.

Sub-prime loans have the original borrowing itself, and also derivative products like securitizations based on sub-prime loans sold to investors in the secondary markets. However the chunk of this sub-prime credit segment is represented by sub-prime mortgages, or home loans.

The sub-prime loan rates are affected by the quantum of the loan, the income capacity of the borrower, the past credit records (delinquency) and the quantum of down payment. The pricing of the loan or its rates are fixed by using what is called risk based pricing. This may vary with changing economic scenario.

Sub-prime loans can be differently structured. The most common among them is known as the Adjustable Rate Mortgage which is characterized by the fixed interest rate charge in the initial stages and then getting converted into a floating rate based on some benchmark indexes, e.g. LIBOR plus an added margin. The 3/27 and 2/28 ARMs are some of the better known ones.

On the flip side this practice of granting loans to borrowers with suspect credit worthiness can cause financial disequilibrium to the individual and on a mass scale to the lending institution. This is because initially due to the fixed rate charged in case of Adjustable Rate Mortgage the interest payment is low but when it gets converted into a floating rate the interest burden goes higher. This results in the number of foreclosures skyrocketing which recently caused a huge financial turmoil known as the sub-prime meltdown.

The bane of this type of lending lies in the fact that the lenders liberally dispersed these loans in the period when the interest rate was low and liquidity of capital high during 2004-2006 without taking enough care to critically appraise the loan applications and jumped into the bandwagon to make some fast profits. Hence when the foreclosures skyrocketed they faced serious crisis.

If one takes a closer look at the pros and cons of sub-prime loans it surely becomes a hotly debated topic with the arguments both for and against. The supporters of this practice arguments that it helps people who in normal case would not have obtained loans for automobiles, credit cards and homes etc to have access to funds. Whereas the fact that sub-prime loans can come with unfavorable conditions ranging from high interest rates, excessive fees and short grace periods are and this possibly can have disastrous effect on an individual as is seen currently points that the anti group puts forth as their arguments.

Nonetheless the securities using sub-prime credit as their collaterals are very much common and popular in the marketplaces across the globe along with investment running into billions of dollars in Uncollateralized Debt Obligation which are based on the cash flows from Sub-prime Credit.

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