Video Captions: Algebra Applications: What Is a Subprime Mortgage?

[Music]

Narrator: Two families are buying a house.

Each takes out a thirty-year mortgage for one hundred

thousand dollars.

One family has a monthly mortgage payment of five

hundred and seven dollars, but the other family has a

mortgage payment of six hundred and

thirty-two dollars.

Clearly one family is paying back the loan with a higher

interest rate than the other family.

In fact, the first family has a four point five percent

interest loan while the other family has a six point five

percent interest loan.

Why does this happen?

The reason that different people pay different mortgage

amounts has to do with their credit score.

A credit score is a number that banks use to determine

the interest you will be charged for a loan.

There are several different credit scores, but one that is

used a lot is the FICO credit score, which has a range from

three hundred to eight hundred and fifty.

The higher a person's FICO score the lower the interest

rate they will be charged.

The lower a person's FICO score the higher the interest

rate they will be charged.

A FICO score determines how much of a credit risk you are.

This table shows the national distribution of FICO scores.

In particular, look at the third column of data.

As your FICO score goes up the less likely you are to default

on your loan.

As you can see from the graph more than fifty percent of

people have a FICO score greater than seven hundred.

These people have a combined delinquency rate of

eight percent.

As a result banks will entice these borrowers with a lower

interest rate.

This box and whisker plot shows that the median FICO

score is seven hundred and twenty-three.

This means that half of all borrowers have a FICO score

greater than seven hundred and twenty-three, and half have a

FICO score less than seven hundred and twenty-three.

Those in the upper range have a very small delinquency rate.

There is roughly twenty-five percent of people who have

credit scores between six hundred and seven hundred.

These people are a higher credit risk and banks will

charge them a higher interest rate.

One type of mortgage that people in this category get is

called a sub prime mortgage.

This table shows the different interest rates charged based

on FICO scores.

Note that interest rates vary from time to time, but what is

constant is that the higher FICO scores lead to a lover

interest rate.

Let's compare the mortgage payments for two different

FICO scores.

Open your amortization table template.

Move your cursor to cell B2.

Suppose that one person's FICO score is eight hundred.

According to the table their interest rate would be four

point five five three percent.

Input this value into cell B2.

Look at the value in cell B4.

This is the monthly mortgage payment.

Cell B5 shows the total amount that this person will pay into

the loan.

Scroll down the spreadsheet to see when the payment on the

principal exceeds that on the interest.

It takes one hundred and seventy-eight months, and at

that point the person has paid back about one-third of the

loan amount.

Now compare this to someone with a score of six fifty.

According to the table their interest rate would be five

point five nine six percent.

Input this value into cell B2.

This table shows how much more difficult it is for someone

with a sub prime mortgage.

Not only do they have a higher monthly payment, but they gain

equity on the house much more slowly than someone with a

good credit rating.

On top of that, the person with the lower FICO score has

a higher probability of defaulting on the loan.

Here is the table again but with additional column added

for the probability of a delinquency.

This means that for every one hundred mortgages to people

with a credit score of eight hundred only one percent

will default.

However, for every one hundred mortgages to people with a

credit score of six hundred and fifty, fifteen percent

will default.

But a default on a thirty-year loan can happen at any time

during the three hundred and sixty month repayment period.

We can run a simulation to see what the default on these

loans could look like.

Return to the spreadsheet tablet and go to the very top

of column G.

Add this column heading.

Press ENTER.

Make sure the cursor is on the cell above G1.

We will conduct a probability experiment using what we know

about lenders with this credit score.

Basically we want to generate random numbers from one

to one hundred.

Input this formula.

If you press control and R the formula generates a new

random number.

Scroll down and you will see that random numbers from one

to one hundred have been generated for all three

hundred and sixty payment periods.

If a number is less than or equal to fifteen then we

consider that a defaulted loan.

Depending on when it occurs the loan balance owed to the

bank also varies.

Move the cursor to the top of column H.

Add this label.

Press ENTER.

Make sure the cursor is above cell H1.

Our simulation will work like this.

If a value in column G is fifteen or less then that is a

defaulted loan and we'll treat the loan balance as money that

the bank has potentially lost.

Input this formula.

Press ENTER.

Scroll down column H and you will see all the defaulted

mortgages, each with a different loan value.

Let's add them up.

Go to cell J1 and input this formula.

Press ENTER.

Since these are random numbers your results will vary but the

default amount will likely be in the range of two to four

million dollars.

As the number of sub prime mortgages increase so does the

amount of bad debt.

Compare these results to the situation with someone with a

credit score of eight hundred.

You'll need to change the following spreadsheet cells.

Change the value in the B2 to four point five five three.

Change the formula at the top of column H to the one shown

in the table.

After making the changes press control R and re-run

the simulation.

You'll see that the amount of loan defaults in terms of

dollar amounts is much smaller.

We are now closer to understanding what caused the

mortgage crisis of 2008.

One key factor was the number of loan defaults and this was

due to an increasing number of sub prime loans.

But what other factors could have made the problem worse?

What caused an increase in loan defaults?

For that we need to look at another type of mortgage known

as an adjustable rate mortgage.