Against the backdrop of news reports on high mortgage delinquency rates, this article examines recent trends in mortgage lending and compares the prime and subprime markets in particular.Mortgages

Calvin T. Ho

Sumit Agarwal

English

Research Papers in Economics

Comparing the prime and subprime mortgage markets 
by Sumit Agarwal, financial economist, and Calvin T. Ho, associate economist
Against the backdrop of news reports on high mortgage delinquency rates, this article 
examines recent trends in mortgage lending and compares the prime and subprime 
markets in particular.
Chicagﾭo Fed Letter
ESSAYS ON ISSUES                                               THE FEDERAL RESERVE BANK                          AUGUST 2007
                                                                                 OF CHICAGO                                                          NUMBER 241
1.  Mortgage delinquency rates
Note: The delinquencies are for mortgages that are 30, 60, and 90 days past due.
Source: Mortgage Bankers Association.
1998 ’99 2000 ’01 ’02 ’03 ’04 ’05 ’06 ’07
0
4
8
12
16
Conventional prime mortgages
Conventional subprime
mortgages
All mortgages
percent
In this Chicago Fed Letter, we analyze 
the different mortgﾭagﾭe types (prime 
versus subprime) and products (adjust-
able-rate versus fixed-rate) to explain 
differences in mortgﾭagﾭe delinquency 
rates over time and across the Seventh 
Federal Reserve District.1 In ligﾭht of 
recent news reports 
about the problems 
in the subprime lend-
ingﾭ market, our pur-
pose is to document 
the recent trends in 
mortgﾭagﾭe lendingﾭ 
and analyze the risingﾭ 
level of delinquencies 
in the subprime mort-
gﾭagﾭe market. 
We show that the sub-
prime mortgﾭagﾭe mar-
ket is facingﾭ substantial 
problems, as measured 
by delinquency rates, 
while the prime mort-
gﾭagﾭe market is expe-
riencingﾭ more typical 
delinquency rates, i.e., 
at historical averagﾭes 
(see figﾭure 1). Within the subprime 
mortgﾭagﾭe market, we observe a sub-
stantial increase in delinquency rates, 
mostly for adjustable-rate mortgﾭagﾭes 
(ARMs). Since the subprime ARM 
market is less than 7.5% of the overall 
mortgﾭagﾭe market and a vast majority 
of subprime loans are performingﾭ 
well, we believe that the subprime 
mortgﾭagﾭe problems are not likely to 
spill over to the rest of the mortgﾭagﾭe 
market or the broader economy. How-
ever, lookingﾭ at the five states in the 
Seventh District, we find a substantial 
gﾭrowth of adjustable-rate subprime 
lendingﾭ in Indiana and Michigﾭan—
states that have experienced recent 
slowdowns in economic activity. We 
also find that Indiana and Michigﾭan 
have higﾭher delinquency rates than 
the national averagﾭe. 
What are prime, subprime, and  
Alt-A mortgages? 
The main difference between prime 
and subprime mortgﾭagﾭes lies in the risk 
profile of the borrower; subprime mort-
gﾭagﾭes are offered to higﾭher-risk borrow-
ers. Specifically, lenders differentiate 
amongﾭ mortgﾭagﾭe applicants by usingﾭ 
loan risk gﾭrades based on their past 
mortgﾭagﾭe or rent payment behaviors, 
previous bankruptcy filingﾭs, debt-to- 
income (DTI) ratios, and the level of 
documentation provided by the appli-
cants to verify income. Next, lenders 
determine the price of a mortgﾭagﾭe in a 
gﾭiven risk gﾭrade based on the borrower’s 
credit risk score, e.gﾭ., the Fair, Isaac, 
and Company (FICO) score, and the 
size of the down payment. 
Lenders gﾭenerally chargﾭe the prevailingﾭ 
prime mortgﾭagﾭe rates to borrowers with 
lower credit risks as reflected by their havingﾭ met a minimum FICO score re-
quirement and their havingﾭ a sufficient 
down payment. Generally, subprime 
borrowers pay 200 to 300 basis points 
above the prevailingﾭ prime rates. Oth-
er costs associated with risk-based pric-
ingﾭ in the subprime mortgﾭagﾭe market 
include higﾭher upfront origﾭination 
fees (e.gﾭ., application fees) and pre-
payment penalties.      
Finally, borrowers who have relatively 
gﾭood current credit scores, but who fail 
to provide sufficient documentation to 
verify income or who have higﾭh DTI 
ratios, are eligﾭible for Alt-A loans. Of 
the nonprime loans, Alt-A loans are 
considered to be the least risky. Alt-A 
borrowers gﾭenerally have credit scores 
fallingﾭ between those of prime and 
subprime borrowers. 
Accordingﾭ to the Mortgﾭagﾭe Bankers 
Association, prime mortgﾭagﾭes make up 
about 80% of the mortgﾭagﾭe market, 
subprime mortgﾭagﾭes about 15%, and 
Alt-A loans about 5%. These figﾭures 
represent the stock of mortgﾭagﾭes out-
standingﾭ as of 2006.
The interest rates for prime, subprime, 
and Alt-A mortgﾭagﾭes can be fixed for 
the term of the loan or adjustable after 
a predetermined period (typically, one, 
three, or five years), dependingﾭ on the 
financingﾭ needs and characteristics of 
the borrower. 
Mortgage market 
size and growth
The residential mort-
gﾭagﾭe market in 2006 
was $10 trillion, rep-
resentingﾭ one-quarter 
of the total debt mar-
ket in the U.S. Over 
the past few years, the 
$1.5 trillion subprime 
mortgﾭagﾭe market has 
experienced expo-
nential gﾭrowth. Ac-
cordingﾭ to Inside 
Mortgﾭagﾭe Finance 
Publications, sub-
prime mortgﾭagﾭes ac-
counted for over 20% 
of all mortgﾭagﾭe origﾭi-
nations in 2006, up 
from 6% in 2002; the Alt-A mortgﾭagﾭe 
market alone gﾭrew from $85 billion in 
2003 to $400 billion in 2006.2 
Adjustable-rate mortgﾭagﾭes have fixed 
interest payments initially and adjust 
after a specified interval to a new in-
terest rate that is based on the prime 
rate at that time. Data show that ARMs 
have gﾭained popularity over fixed-rate 
mortgﾭagﾭes across both prime and sub-
prime markets. They usually carry 
comparatively low initial rates, which 
increase the appeal of this type of 
mortgﾭagﾭe. The percentagﾭe of prime 
loans that are ARMs, for instance, 
jumped from 10.6% 
in December 2001 to 
18.2% in December 
2006, while the frac-
tion of subprime 
ARMs rose from 
27.6% in December 
1998 to about 50%  
in December 2006. 
Evolution of the 
subprime mortgage 
banking industry
Subprime mortgﾭagﾭes 
gﾭained popularity in 
the early 1990s, when 
fallingﾭ interest rates 
made them appeal-
ingﾭ to homeowners 
as a way to refinance 
existingﾭ mortgﾭagﾭes, 
consolidate debt, or 
finance home improvements. The 
mortgﾭagﾭe business landscape transformed 
as technologﾭy made it possible to auto-
mate credit checkingﾭ and underwritingﾭ 
procedures, thereby sigﾭnificantly reduc-
ingﾭ the time and expense involved in 
these processes. Furthermore, the use 
of credit scoringﾭ systems made it possi-
ble to expedite the evaluation of mort-
gﾭagﾭe applicants’ risk profiles and increase 
the volume of applications processed. 
The expansion of the subprime mort-
gﾭagﾭe market has helped make home-
ownership possible for households that 
may not have qualified in the past. While 
the gﾭains in homeownership are broad 
based, they are especially largﾭe for the 
minority and low-income communities.3 
However, weaker financial conditions 
and lower credit scores of the subprime 
borrowers have led to a higﾭher cost of 
borrowingﾭ; this, combined with declin-
ingﾭ or flat house prices and risingﾭ in-
terest rates, has put upward pressure 
on the delinquency rates for subprime 
ARM borrowers. 
Delinquencies in prime and  
subprime mortgages
Data provided by the Mortgﾭagﾭe Bankers 
Association indicate that the overall 
mortgﾭagﾭe delinquency rate has been 
hoveringﾭ around 4% since the early 
1990s. Althougﾭh the rate has edgﾭed up 
to about 4.9% in the past 12 months,  
1998 ’99 2000 ’01 ’02 ’03 ’04 ’05 ’06 ’07
0
4
8
12
16
Conventional prime ARMs
Conventional subprime ARMs
percent
2.  Adjustable-rate mortgage (ARM) delinquency rates
Note: The delinquencies are for mortgages that are 30, 60, and 90 days past due.
Source: Mortgage Bankers Association.
percent
3.  Prime mortgage delinquency rates, by region
NoteS: The delinquencies are for mortgages that are 30, 60, and 90 days past due.  
All delinquency rates are nonseasonally adjusted.
Source: Mortgage Bankers Association.
1998 ’99 2000 ’01 ’02 ’03 ’04 ’05 ’06 ’07
0
1
2
3
4
5
United States
Iowa
Indiana
Illinois
Michigan
WisconsinMichael H. Moskow, President; Charles L. Evans, 
Senior Vice President and Director of Research;  Douglas 
Evanoff, Vice President, financial studies; Jonas Fisher, 
Economic Advisor and Team Leader, macroeconomic  
policy research; Richard Porter, Vice President, payment 
studies; Daniel Sullivan, Vice President, microeconomic 
policy research;  William Testa, Vice President, regional 
programs and Economics Editor; Helen O’D. Koshy, 
Kathryn Moran, and Han Y. Choi, Editors; Rita 
Molloy and Julia Baker, Production Editors.  
Chicago Fed Letter is published monthly by the  
Research Department of the Federal Reserve 
Bank of Chicago. The views expressed are the  
authors’ and are not necessarily those of the  
Federal Reserve Bank of Chicago or the Federal 
Reserve System. 
© 2007 Federal Reserve Bank of Chicago  
Chicago Fed Letter articles may be reproduced in 
whole or in part, provided the articles are not  
reproduced or distributed for commercial gain 
and provided the source is appropriately credited. 
Prior written permission must be obtained for 
any other reproduction, distribution, republica-
tion, or creation of derivative works of Chicago Fed 
Letter articles. To request permission, please contact 
Helen Koshy, senior editor, at 312-322-5830 or 
email Helen.Koshy@chi.frb.org. Chicago Fed  
Letter and other Bank publications are available 
on the Bank’s website at www.chicagofed.org.
  
ISSN 0895-0164
it remains near historical lows (see fig-
ure 1). This is largely because prime 
loans, which make up 80% of the mort-
gage market, have stable delinquency 
rates. Both fixed-rate and adjustable-
rate prime mortgage delinquency rates 
are approximately 2% and 4%, respec-
tively—just around their correspond-
ing historical averages.
Subprime mortgages, on the other hand, 
have exhibited significant increases in 
delinquency rates. In December 2006, 
over 13% of subprime loans were delin-
quent in the U.S., up from about 10% 
during the housing boom a few years 
earlier. More than 14% of subprime 
ARMs were delinquent in December 
2006, up from about 10% two years 
earlier, and over the same period, 
there were twice as many foreclosures 
on homes (i.e., loan defaults leading 
to seizures of homes by lenders). 
Figure 2 shows the delinquencies for the 
prime and subprime ARM markets. In 
recent years, the delinquency rate for 
prime ARMs was below its historical high 
of 4%, but the delinquency rate for 
subprime ARMs increased from 10% in 
September 2004 to 14% in September 
2006. However, over the same period, the 
delinquencies for the fixed-rate prime 
and subprime markets were below their 
historical highs of 2.5% and 16.6%, re-
spectively, and stayed relatively flat. 
The subprime mort-
gage market consti-
tutes about 15% of 
the overall mortgage 
market, and about 
50% of subprime mort-
gages are ARMs. While 
there has been a 40% 
increase in subprime 
ARM delinquencies 
over the past two 
years, the rest of the 
mortgage market, es-
pecially the fixed-rate 
subprime mortgage 
market, has not expe-
rienced a similar hike 
in delinquency rates. 
This suggests that 
about 7.5% of the 
overall mortgage mar-
ket has experienced a 
significant increase in delinquencies, 
reducing the likelihood of any spillover 
effects on the rest of the mortgage mar-
ket. However, the problem may be more 
significant for some states, as we discuss 
in the next section.
Mortgage activity in the  
Seventh District
The growth of the subprime mortgage 
market has varied across the five states 
in the Seventh District. For example, 
the share of subprime mortgages in 
Michigan grew from 2% in 1998 to just 
below 16% in 2006, while the share of 
subprime mortgages in Iowa grew from 
less than 1% in 1998 to 8% in 2006. In 
contrast to Indiana and Michigan, the 
other three states of Illinois, Iowa, and 
Wisconsin had shares of subprime mort-
gages that were below the national  
average of 15.2% at the end of 2006.
Figures 3 and 4 show that Indiana and 
Michigan, which have experienced slow-
downs in the manufacturing sector, have 
reported higher rates of delinquencies—
sometimes twice as high as the nation-
al average in both prime and subprime 
mortgage markets. At the end of 2006, 
the delinquency rates for prime mort-
gages were 4.0% and 4.2% for Indiana 
and Michigan, respectively, while the 
national average was 2.8% (see figure 3). 
At the end of 2006, the delinquency 
rate for subprime mortgages was 21.1% 
in Michigan and 14.2% across the na-
tion. All five Seventh District states had 
higher delinquency rates than the na-
tional average, varying between 14.7%  
in Wisconsin and 21.1% in Michigan 
(see figure 4). 
In addition, Indiana has a higher share 
of subprime mortgages as a share of total 
mortgages, thus exacerbating the im-
pact of the subprime problems. Specifi-
cally, Indiana’s share is 18.3%, or 3.1% 
above the national average.
Can market participants help  
prevent the spread of subprime 
problems?
There are a number of recent public 
and private initiatives that should help 
prevent the spread of the subprime prob-
lems to the broader economy. Freddie 
Mac, a U.S. government-sponsored  
enterprise that issues mortgage-backed 
securities, has indicated that it would 
purchase $20 billion of loans from sub-
prime borrowers facing an ARM reset. 
Fannie Mae, a similar entity, has creat-
ed a product allowing for 40-year home 
loans. Also, financial institutions, such 
as Citibank and Bank of America, have 
set up a $1 billion fund to help provide 
subsidized loans to homeowners who 
percent
4.  Subprime mortgage delinquency rates, by region
Notes: The delinquencies are for mortgages that are 30, 60, and 90 days past due.  
All delinquency rates are nonseasonally adjusted.
source: Mortgage Bankers Association.
0
5
10
15
20
25
United States
Iowa
Indiana
Illinois
Michigan
Wisconsin
1998 ’99 2000 ’01 ’02 ’03 ’04 ’05 ’06 ’07are on the brink of foreclosure. Addi-
tionally, some states have raised funds 
to help homeowners refinance risky 
mortgﾭagﾭes; for example, Ohio has 
raised $100 million for this purpose. 
Other states, such as Pennsylvania, 
New York, and New Jersey, are pursu-
ingﾭ similar strategﾭies. 
Finally, in response to the risingﾭ level 
of delinquencies, lendingﾭ institutions 
have tigﾭhtened credit and underwrit-
ingﾭ standards. Credit spreads on new 
subprime securitizations have increased, 
and subprime securities origﾭinations 
have slowed. 
These measures, togﾭether with better 
disclosure by lenders, efforts to prevent 
lendingﾭ fraud and abuse, and financial 
counselingﾭ for potential and existingﾭ 
borrowers, could gﾭo a longﾭ way toward 
helpingﾭ households keep their finan-
cial obligﾭations more managﾭeable and 
reducingﾭ delinquency rates.
1 The Seventh Federal Reserve District 
comprises all of Iowa and most of Illinois, 
Indiana, Michigﾭan, and Wisconsin.
2 See Inside Mortgﾭagﾭe Finance Publications, 
2006, Mortgage Market Statistical Annual 
2006, 2 vols., Bethesda, MD. 
3 For further details, read the speech by 
Federal Reserve Chairman Ben Bernanke 
at www.federalreserve.gﾭov/boarddocs/
speeches/2007/20070517/default.htm.

Comparing the prime and subprime mortgage markets

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