Question

Explain how the subprime loan market is a market for lemons

Answer 1

Answer : Subprime means "below" prime, for borrowers with credit histories in good standing. The subprime loan market is a market for lemons because of the hidden information. The subprime market serves individuals with questionable or limited credit histories who borrow for houses, cars, and other general purchases.

Although subprime loans were more flexible than regular loans in terms of varying interest rates based on an applicant’s credit history, it was still a market for lemons. Individual with a lower credit score, the higher the interest payment.Subprime mortgage are issued to individual with low credit score at higher interest rates to compensate lenders for additional payment default risk.

While banks did issue these loans, the lemon existed and probed the question: is this person capable of paying back these loans? & from the applicant’s side, the question was: will I be able to pay back these loans?

In 1997 and 1998, borrowers of subprime loans were defaulting and refinancing at higher levels than anticipated, which led lenders with a big loss. Because the market for subprime loans is a lemon, lenders were aware of the possible losses, but could not predict how big of a loss would occur.

These types of loans are called more to extend to families with low incomes, especially to those with a struggling credit history.