In the US they are known as "bad credit mortgages". Here, sub-prime loans are not quite so common that they have earned a nickname, but the phrase has become commonplace since the credit crunch took hold in the summer of 2007. The credit crunch arrived as "bad credit" borrowers in America began defaulting on their repayments, putting the balance sheets of US banks in jeopardy and sparking a global squeeze on lending.

What is a sub-prime loan?

Generally speaking, anything sub-prime is aimed at borrowers with patchy credit histories. The definition has become more complicated over recent years. Sub-prime can now apply even to borrowers who have missed a few credit card or loan repayments, depending on the lender's own criteria.

The term typically refers to mortgage candidates, though any form of credit offered to people who have had problems with debt repayment is classed as sub-prime.

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Background

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Rates on sub-prime deals are typically higher to reflect the extra risk in lending to people who have struggled in the past.

Sub-prime mortgages in the US are not the same as those in the UK. In the US, a sub-prime mortgage starts on a very low rate for a year or two, before switching to a very high rate. In the UK, a sub-prime borrower will start on a relatively high rate of interest, but there are many different kinds of sub-prime lending, depending on the extent of the borrower's past problems.

Extra light, light, medium, heavy or very heavy adverse

These are the categories that sub-prime borrowers are divided into by mortgage lenders. Even these are subject to some variation.

If you are prime, it means that you have a clean credit record. Lenders used to allow minor debts on prime deals, but Moneyfacts says that this is no longer the case.

Light or near-prime essentially means that you have been a few months in arrears on some debt repayments a couple of times in the past. It includes borrowers with no more than two County Court Judgments (CCJs), of up to a maximum of £3,000.

Medium adverse, says Moneyfacts, is defined as up to three CCJs to a maximum of £5,000.

Heavy adverse is four CCJs to a maximum of £10,000, while extra heavy describes borrowers with unlimited CCJs of more than £10,000.

Why is sub-prime such a hot topic?

Poor American homeowners who had taken out sub-prime loans could no longer meet their repayments when they were switched to a higher interest rate, resulting in American banks losing money. This has a knock-on effect in the UK because many British mortgage lenders rely on revenue from selling mortgage debt to US banks, also known as 'securitising'. When US banks began losing cash, they stopped buying these loan books, meaning that UK banks were unable to continue subsidising cheap rates.

Securitisation is a popular funding model for lenders that specialise in sub-prime mortgages, so this market virtually dried up overnight in the UK.

Since then, a general lack of confidence between banks has led to a more widespread decline in interbank funding, so even prime mortgage borrowers are facing higher rates as lenders struggle to generate enough cash to support the highly competitive deals that UK borrowers have grown accustomed to in recent years.

Buy-to-let mortgages for sub-prime borrowers have virtually disappeared since the credit crunch.

The sub-prime market also suffered a setback at the end of 2006, when the Financial Services Authority cracked down on rogue brokers who were misleading borrowers with credit problems by arranging loans that were more expensive than necessary. Brokers earn more commission on sub-prime deals because they are more profitable for lenders.

There are deals still on the market, but the rates are less competitive than they were in early 2007. Furthermore, the amount that can be borrowed on a sub-prime deal has fallen to an average of about 70 per cent of the property's value.

How do I get a sub-prime mortgage?

First, do not assume that you need one. Many borrowers who think that they will have to take out a sub-prime deal may find that another lender is willing to offer a prime deal. For this reason it is usually best to approach a broker. If you are struggling for money, some brokers, such as London & Country and John Charcol, offer their services free. Check your credit record first, using either Experian, Equifax or Call Credit, so you know what to expect.

Once a sub-prime borrower, always a sub-prime borrower?

No. The amount of time that it takes to be classified as "prime" again will depend on the severity of the debt and how well the borrower copes with repayments. Brokers say that it usually takes one to two years of making repayments to clear your name in the eyes of a lender and have your prime status restored.

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BBC: The US sub-prime crisis in graphics

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The UK's very own sub-prime crisis, by housepricecrash.co.uk

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