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Impact of Financial Markets on Economic Stability and Growth: The Case of Sub-Prime Mortgage Lending - page 4 / 42

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1/23/2015

Jamshid Damooei, PhD

4

What Does it Mean…..Continued

The most commonly used mortgage in the subprime market is the 2/28 ARM. This is an adjustable-rate mortgage on which the rate is fixed for two years and is then reset to equal the value of a rate index, plus a margin.

Because subprime margins are high, the rate on most 2/28s will rise sharply at the two-year mark, even if market rates do not change during the two-year period.

If the house has appreciated, this is not usually a problem because the borrower can refinance, if necessary, into another 2/28. While these loans carry refinance costs and typically have prepayment penalties, the costs and penalty can be included in the balance of the new loan if the borrower has sufficient equity.

The borrower who does not have the equity needed to refinance, however, is stuck with the higher payment on the existing loan, which may be unaffordable.

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